Escrow Account: To Establish, or Not To Establish?

In this installment of my series on "Shopping for Mortgages the Right Way" we'll take a closer look at the escrow account for taxes and insurance to understand why it typically makes sense to choose to have an escrow account versus not.

The escrow account is misunderstood by some borrowers in that they think lenders hold this money and earn interest as a way to increase the lender's profits.  As a result some borrowers opt to waive the escrow for taxes and insurance, thinking they can earn the interest rather than the bank.

It's true, the borrower can earn interest if they place a lump sum or budget enough periodically in a side account to cover the property taxes and homeowners insurance when they become due.  But, is it really worth doing this?

To answer this question it's important to know that most lenders will charge a fee should the borrower elect not to establish an escrow account.  Borrowers may be unaware the lender is charged 1/4% of the loan amount by Fannie Mae or Freddie Mac to make a  loan without an escrow account.  The lender will pass this along either in the form of up-front discount points or offer a higher interest rate to the borrower.

However, let's disregard the point made in the previous paragraph for a moment.  Let's do some math to see how much interest you might earn if you choose to pay the taxes and insurance when due.  Assume the following:

• Property Value: $300,000
• Annual Property Taxes: $3,000 (due 12/31)
• Annual Insurance Premium: $1,200 (due 12/31)

If you set aside $4,200 at the beginning of the year in an account earning today's interest rates, you'll be doing well to earn 1%.  Assuming daily compounding of the interest, your balance on 12/31 would be $4,243.  You've earned a whopping $43!  And, this assumes you visit the tax office and your insurance agent on New Year's Eve to pay those bills, in order to earn the maximum interest.

In addition, if the lender required you to pay .25 discount points up front on a loan amount of $200,000, that would equate to $500, taking you years to recover that amount in interest earnings on your savings account.  Or, if the lender offered you a higher rate as a result of having to cover the escrow-waiver fee, the extra .125% added to your interest rate would make a payment difference of $14.47 per month, or $173.64 per year, putting you in the red!

Knowing this, doesn't it make sense to establish an escrow account?

Closing Costs: What the Borrower Should Expect

In my last blog post we discussed the two-part question mortgage shoppers should be asking;

1. What is your rate, and...
2. What are the fees (i.e. closing costs) associated with this rate?

In this post we'll look at what the closing costs consist of, so that you can better compare quotes from lender to lender.  Note - fees may vary depending on the state in which the mortgage transaction is taking place.  For the purpose of this post we are using the state of Georgia as an example.

There are two categories of settlement charges that we need to distinguish:

1. "Closing costs" consisting of one-time fees for services to close the transaction
2. "Prepaid & Escrow Fees" consisting of prorated interest, homeowners insurance and property taxes, and the establishment of an escrow account.

We'll explore #2 in a subsequent post.

First, let's look at some standard fees one can expect to find.  These fees should be pretty comparable regardless of the lender as they are all 3rd-party fees, but the lender is required to quote them:

NOTE: RATES OR FEES QUOTED BY LENDERS ARE NOT GUARANTEED UNTIL CERTAIN MILESTONES HAVE BEEN REACHED.  WE WILL DISCUSS SOME OF THESE MILESTONES AND THE "GOOD FAITH ESTIMATE" - AN OFFICIAL AND REGULATED DOCUMENT - IN SUBSEQUENT POSTS.

* REQUIRED SERVICES SELECTED BY THE LENDER *
Appraisal
Credit Report
Flood Certification
* TITLE SERVICES *
Attorney's Fee
Title Search/Exam
Title Binder
Courier Fee
Lender's Title Insurance
Owner's Title Insurance (purchase only)
Closing Protection Letter
Wire Transfer
* GOVERNMENT FEES *
Intangible Tax (0.3% of loan amount)
Deed Transfer Tax (0.1% of purchase price)
GRMA ($10.00)
Recording Fees

As one can see the list of 3rd-party fees is quite extensive.  Again, it's worth noting that these fees should be pretty comparable.

Next, here's a list of fees charged by the lender.  This list can vary not only in the name of a fee, but in the amount as well.  It's incumbent upon the borrower to understand these fees, so some additional definition is included below:

FEE NAME	A.K.A / NOTE
Origination Fee	a.k.a. "Administration Fee," "Underwriting/Processing Fee"
Discount Points	Prepaid interest to reduce interest rate (a.k.a. "Buy-down")

These two fees can vary widely.  The Origination Fee should be no more than $1,000.  As for the Discount Points, my advice is to ask for a quote with zero discount points.

Key Points:

• There are always closing costs associated with a mortgage transaction.
• There is no such thing as a "no-cost" transaction.
• As a borrower you will be paying these fees, unless the seller (in a purchase transaction) agrees to pay all or some of the closing costs, in one form or another, including:
• Higher Interest Rate
• Out of Pocket
• Added to Loan Amount (refinance only)

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Mortgage Shopping: Rates vs. Closing Costs & Other Fees

As a mortgage advisor, the first question I usually receive from prospective borrowers is "What is your interest rate for a (30 or 15-year fixed, etc.)?"  If you are shopping for a mortgage and you are asking this question to lenders, the question you should be asking is this:

(1) What is your rate and...

(2) what are the closing costs associated with this rate?"

Let me explain the purpose of this 2-part question.  We'll consider a 30-year fixed rate loan program for this illustration.

First, it's important to know that you as the borrower aren't simply borrowing money. When you get a mortgage you are really "buying" an interest rate.  You can really get any rate you want within a range.  It's simply a matter of how much you are willing to pay for the rate.

Bottom line?  The lower the rate, the more you will need to pay for that rate in terms of closing costs.  (We'll discuss this in greater depth in my next blog post.)

Next, let's take a peek at the mortgage officer's desk.  A mortgage officer has a rate sheet that will list a range of rates that looks something like the following:

Interest Rate	Price
4.125%	(0.500)
4.250%	0.000
4.375%	1.000

What the Price (a.k.a "points") column shows is simply how much of a "premium" or "discount" the rate is worth (or costs) to the lender:

• A price above 0 means the lender receives a premium, or "bonus" if you will, for selling that rate.
• A price below 0 represents the "discount" meaning the lender (or the borrower) will need to fork up some dollars to sell this discounted rate.
• A price of 0 is the "par" rate, meaning there is no discount or premium paid or received by the lender.

Each point represents 1% of the loan amount.  So, if you the borrower opts for the 4.125% rate, you can expect to pay 1/2% of the loan amount for this rate, unless the lender is willing to eat this amount.  However, 1/2% of any loan size will more than likely eat up the lender's commission, so don't count on the latter.

On the other hand if you opt for the higher rate of 4.375%, the lender now has a premium of 1% of the loan amount.  By law, the mortgage officer can not be paid on this premium, but she can apply it to the borrower's settlement charges (i.e. closing costs and other fees).  Hence, the total fees charged to the borrower will be reduced.

Rule of Thumb: the lower the rate, the higher the fees, and vice versa.

My next posting will discuss closing costs and other settlement charges in greater depth. Feel free to pauljanofsky@certuswealth.com.

Mortgage Pre-Approval; Does It Have Value?

If you are a real estate professional, you will not spend time with a prospective buyer who is not qualified for financing.  I've heard several stories over the last several months about agents spending time showing houses, even getting contracts on listings, only to find out later the buyer did not qualify for financing.  The worst story I heard occurred recently when only two days before closing the buyer was deemed unqualified and the contract fell through.

For those buyers who present you with a pre-approval letter from a mortgage company, how can you know if the pre-approval process was comprehensive enough to assure that you will have a qualified buyer?  After all, the proverbial pendulum is still swinging far to the opposite side of where it was in 2005, when all one needed was a "pulse" to qualify for a mortgage.

Most pre-approval letters will state something such as the following:

"Congratulations!  You have been pre-approved for a home purchase with a price not to exceed <price> and a loan amount not to exceed <loan amount>, subject to the following conditions..."

The condition list can be endless, leaving plenty of room for error on the part of the mortgage originator.

While the majority of mortgage originators will require a credit report as part of the pre-approval process, they may not even look at a pay stub or tax return to determine qualifying income, opting instead to simply base their pre-approval on the borrower's "word" about income, assets and other debt obligations (e.g. alimony or child support which do not show up on a credit report).

If a prospective buyer presents you a pre-approval letter, contact the issuing lender and ask what documents were collected as part of the pre-approval.  Here's a short list of documents that are are common:

• Most recent W2 for salaried employees
• Tax Returns; most recent 2 years' for commission/bonus-based employees or self-employed individuals
• Corporate Tax Returns (2 years') for self-employed individuals, depending on how their business is structured (e.g. Sole Proprietorship, Partnership, Subchapter S Corporation, etc.)
• Credit report will show monthly debt obligations, legal judgements, tax liens, etc.
• Divorce decree will dictate alimony and/or child support payments
• Proof of legal residency in the United States

If you have any questions about the pre-approval process, or other real estate finance issues, feel free to contact me at (770) 597-1423.