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?