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Borrowers today are faced with an important decision on their home loan; whether to have their lender collect monthly escrows for annual tax and homeowner’s insurance bills, or to pay these expenses out of their own pocket at the time they are due. Conventional wisdom says to do whatever you can to avoid escrows. This affords you the opportunity to earn interest on these funds instead of your bank. The real answer to this question may not be so easy.

Escrows occur when a lender collects a prorated portion of your annual property taxes and homeowner’s insurance premium every month from a borrower. Think of it as a savings account held by the mortgage lender. When the bills come due, they are paid directly from that account. This way the borrower is relieved of the responsibility of planning for what can be a major annual expense and does not run the risk of insufficient funds to cover these bills. Escrows are typically required whenever a borrower puts less than a 20% down payment on a home and optional when the borrower has more than a 20% equity stake in their home. Lenders like this arrangement because they don’t have to worry about borrowers not paying their tax bills and a tax lien getting in the way of their own security position. It also allows lenders to earn interest on funds in the escrow account until it is tapped for taxes and insurance.

In today’s environment the argument against escrows is not as strong as it once was. Liquid assets are not earning the type of interest they once were when short term interest rates were in the high single or double digits. Therefore, the earnings on those funds for the borrower, is modest. Furthermore, in an environment where employment and income is less reliable, and housing values weak, it might make sense to take advantage of the budgeting offered by an escrow account rather than face the risk of a shortfall come tax time. That shortfall could mean tax penalties, dramatically increased hazard insurance premiums, and a higher loan payoff as a result of these arrearages if you are trying to sell your house.

On the other hand, there is something to be said for controlling your own destiny. Those borrowers who have significant liquid reserves available, enjoy a high level of disposable income, and are able to effectively budget for their expenses may be better served by retaining this risk and keeping the modest earnings provided through the investment of accrued tax and investment reserves.

Some borrowers may simply not have much of a choice. Fewer borrowers are able to come up with the 20% down payment necessary to avoid escrows in a difficult economy. In addition, combo loans that offered the benefit of an optional escrow by combining a first mortgage providing financing for 80% of the purchase price combined with a purchase second mortgage that provides an additional 5-15% are not as easy to come by. The second mortgages also tend to carry higher rates and have shorter repayment periods, meaning a higher overall monthly housing expense.

The scheme that makes the most sense for a borrower really depends on their circumstances. A borrower who has the choice of whether to escrow or not should consult a Certified Mortgage Planning Specialist (CMPS®) to see if there are specific benefits to an escrow arrangement such as a lower interest rate, and what the dollar impact is of the escrow savings in order to make an educated decision.