Buying a home is expensive. On closing day, you’ll pay for everything from title insurance and home inspections to the credit report that mortgage lenders run on you.
Brian Koss, executive vice president of Mortgage Network in Danvers, Massachusetts, said that property taxes and insurance are two expenses that homebuyers often neglect to plan for when buying a home, even if they are mentally prepared to handle the down payment and closing costs involved in taking out a mortgage.
"There are closing costs and then there are costs that you pay at closing. Taxes and insurance are costs that you pay at closing," Koss said. "That might sound like semantics, but that's the best way to explain closing costs.
"The escrow costs can be a lot of money depending on the town in which you are buying," he continued. "Some places have crazy high real estate taxes. If often catches homebuyers by surprise."
The tax and insurance surprise
While homebuyers often worry about mortgage rates, whether they can avoid private mortgage insurance and how much their lenders will charge in origination fees, they often forget to think about property taxes and homeowners insurance. That is a mistake.
Most buyers will create what is known as an escrow account with their mortgage lenders when they buy a home. Every month, they'll pay a bit extra with their mortgage payment. That extra money will be deposited in this escrow account. Their lenders will then use the money in this account to pay homeowners' property taxes when these payments come due two times a year. Lenders will also use the money in this account to pay the homeowners insurance bills that buyers must pay each year.
Most lenders require this escrow account. These accounts, which do not generate interest for buyers, do make sure that buyers won't forget to pay their taxes and homeowners insurance on time. It also forces buyers to save for these payments each month, instead of having to scramble to come up with thousands of dollars when these payments come due.
The odds are that your lender will require an escrow account for all mortgage types, whether you are applying for a fixed-rate mortgage or one that comes with adjustable rates.
The extra financial challenge for buyers comes on closing day. That's because lenders require buyers to deposit a certain amount of monthly tax and insurance payments into their new escrow account when the home sale closes. This way, lenders figure, they'll have enough money in the escrow account to make the first property tax and insurance payments on behalf of these buyers.
How much you'll have to bring to the closing table to cover your property-tax and insurance obligations will vary. Tal Frank, president of Columbus, Ohio-based Physician Loans, said that most buyers will have to provide two to five months of tax payments to fund their escrow accounts at closing.
Property taxes add up
But Frank says that this is only the most basic of answers. Some counties might require that homebuyers deposit an entire year's worth of property taxes into their escrow accounts at closing. Lenders will also require that buyers deposit an extra two months of property tax payments in their escrow accounts. This is a cushion that lenders require to make sure that buyers always have enough money in their escrow accounts to cover their tax bills, even if these bills are higher than what lenders estimate they’ll be.
Frank points to Michigan. In Michigan, buyers pay their taxes ahead when they buy a home. Their lenders might require them to deposit from eight to 10 months of tax payments in their accounts at closing. These lenders will also require two additional months of tax payments for the escrow cushion. This means that some buyers in Michigan might have to come up with a full 12 months of tax payments on closing day.
That can be a lot of money if a buyer's property tax bill is $4,000, $6,000 or more each year.
Planning for the financial hit
Frank, though, says that there is no way around this financial hit.
"We always tell people when we are preparing them to buy a home that they have to budget for three things: the down payment, closing costs and escrow costs," Frank said. "They can then save up to cover those costs or they can seek some financial assistance from family members in the form of gifts that they don't have to pay back. The earlier they start preparing for this in the process, the better."
Then there is homeowners insurance. David Meltzer, owner of East Insurance Group in Baltimore, said that the amount of money homebuyers need to bring to the closing table to cover homeowners insurance will vary from state to state. But most owners can expect to pay about $1,000 a year for their homeowners insurance policy.
At closing, most lenders will require that buyers either deposit the first six or 12 months of their homeowners insurance policy premiums in their escrow account. Lenders will also require, as they do for property taxes, that owners deposit an extra two months of insurance payments in their escrow account. These extra two months again act as an emergency reserve.
If your homeowners insurance, then, costs $70 a month, you can expect to pay from $420 to $840 depending on whether your lender requires you to deposit six or 12 months of payments in your escrow account at closing. You can then add $140 to that amount, the two months of reserve insurance payments.
The benefits of escrow
Setting up an escrow account does come with a small cost. Frank said that most lenders will charge a one-time fee of $70 for the tax portion of the account and a fee of $30 for the insurance portion. If your lender does allow you to opt out of creating an escrow account, it will probably charge you a one-time fee of up to .25 percent of your loan amount, Frank said.
Meltzer said that all homebuyers should create an escrow account with their lenders.
“Escrow is a good thing,” Meltzer said. “I think they benefit every homeowner. Even if you are disciplined enough to save enough money to cover these bills, you still have to worry about not getting the bill in the mail on time or about forgetting to make your payment. With escrow, you don’t have to worry about that.”
The only exception, and Meltzer considers it a rare one, are those homeowners who are financially disciplined enough to invest the money that they would have deposited in their escrow account. Such owners can then earn interest on these funds, something they won’t do if they place these dollars in their lender’s escrow account.
“If a person is a seasoned investor who keeps money active all the time and knows the status of every penny at every moment, sure, that person might be better off without an escrow account,” Meltzer said. “But that is a rare person. Most people don’t do that. Most people don’t make money by having money. They make money at their jobs.”
Frank agrees. He says that even if homeowners were disciplined enough to deposit the money they put into escrow each month into a traditional savings account, the amount of interest they would earn would be minimal.
"We're talking tens of dollars here instead of thousands of dollars," he said.