When you buy a home with a down payment under 20%, your lender may require that you set up an impound account, or escrow account, and make a deposit on private mortgage insurance (PMI), homeowners insurance, property taxes and any other required forms of insurance.
An impound account is an account maintained by the mortgage company to collect tax and insurance payments necessary to keep the home, but are not part of the mortgage. The annual cost of each form of insurance and tax is divided into a monthly amount and added to your mortgage payment.
Because borrowers who make a low down payment are considered a higher risk because they have less personal stake in the home, lenders want assurance that the state will not seize the home for non-payment of property taxes, and that borrowers will not be without homeowners insurance if the home is damaged. An impound account protects the lender by ensuring that the only entity that may become owner of the home in case of default is the lender.
While the main purpose of an impound account is protecting the lender, homeowners can also benefit from the account as well. Because insurance and property taxes are paid monthly, there is no need to come up with a significant amount of money when the bills become due. Many financial advisers even recommend escrow accounts for homeowners.
If the mortgage company fails to pay the bills, the homeowner is still on the hook for the bills. This underlines the importance of monitoring the impound account and staying aware of due dates for the payments.
Your monthly mortgage statement likely shows the balance of the impound account. Federal regulations also require lenders review the borrower's impound account each year to make sure the correct amount is being collected. If too little is collected, the lender will ask for more; if too much money accumulates in the impound account, the lender is required to refund the homeowner.
If your mortgage loan does not include an impound account, you must plan for potentially large expenses. This should be budgeted alongside your monthly mortgage payments. You may have the option of setting up your own impound account, even if you make a low down payment, but most lenders charge borrowers a higher interest rate to do so. You also have the option of requesting a voluntary impound account if it is not required by your lender.
If you have property taxes of $1,200 annually, the lender will collect $100 each month. If the home owners insurance premium is $600 every year, an additional $50 will be collected. This $150 impound payment is added to the principal and interest payment for the mortgage to create a total mortgage payment, which is referred to as PITI (principal, interest, taxes and insurance).
Even with a fixed rate mortgage, your monthly mortgage payment will be subject to change with an impound account because, as property taxes and homeowners insurance change, the monthly payment will fluctuate. This fluctuation may be small, around $10-20 per month, or it may be substantial, depending on the area.
A required impound account will also decrease the amount a borrower may put into an emergency fund or interest-yielding investments. Because lenders require at least a few months' worth of insurance and tax payments at closing, the startup costs of the escrow account can increase the amount of money a borrower needs to buy a home.
When sufficient equity in the home is achieved, lenders can often be convinced to remove the impound account requirement.