How Do I Figure Escrows?

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September 6, 1999

"My loan officer tells me I need to deposit $1157 into an escrow account at closing to take care of future taxes and hazard insurance payments, but when I asked him where that number came from he said 'it is set by HUD' and was unable to explain it further. Can you shed any more light on this?"

Lenders generally take over responsibility for the payments of taxes and insurance so that they can be sure that the payments are made. They require that an escrow account be established with the borrower's funds, from which the lender makes the payments as they come due. The escrow account is established with a deposit that the borrower provides at closing. To assure themselves that there will always be enough money in the account, lenders ask for more than they actually need as a "cushion".

Since lenders usually get to keep the interest on escrow accounts, in years past, many of them maintained unreasonably large cushions. To deal with that, the Department of Housing and Urban Development (HUD) issued a ruling that placed a ceiling on the size of escrow accounts, which in turn limited the amount the lender could ask the borrower to deposit at closing.

The rule is that the deposit cannot exceed the amount needed to prevent the balance from falling below an amount equal to 2-months worth of tax and insurance payments at its lowest point during the year. While HUD does not do a lot of enforcing, my impression is that all but a handful of lenders follow the HUD rules.

Here is how to calculate the maximum initial deposit yourself.

Add the annual taxes and insurance premiums and divide by 12. This is the amount that will be added to your mortgage payment every month.
List 12 months running down the page beginning with the month in which your first payment is due.
In the column next to the first one, enter the tax and insurance payments next to the month in which they are due.
In the third column, show the amount in the escrow account assuming there is no initial deposit. The monthly payments made by you add to the account while the tax and insurance payments made by the lender reduce it.
Scroll down to the month that has the largest shortfall. To the shortfall add 2-months of payments (the allowable cushion). The total is the maximum deposit under HUD's rules.

Here is an example:

The first payment is due in November.
Total taxes and insurance are $3468, or $289 a month.
Hazard insurance of $618 is due in March.
County taxes of $432 are due in April.
School taxes of $2418 are due in August.

Assuming no upfront deposit, the low point of the escrow account is reached in August when school taxes are due. Through August, total payments from the escrow account are $3468 whereas only 10 payments have been made into the account totaling $2890. The account would therefore be short by two monthly payments, or by $578. The lender is also allowed a cushion of two months, which is $578. Hence, the total required deposit to the escrow account would be $1156.

Borrowers who don't want to be bothered checking the lender's calculation of the required escrow deposit are unlikely to be taken advantage of because lenders can't do it without violating the law. I suggest that you focus your attention on the many legal ways that lenders and mortgage brokers can pick your pocket.

At the same time, unintentional mistakes do occur at the closing table which affect the allocation of costs between sellers and buyers. A recent letter described a $500 mistake of this sort, which the letter-writer discovered by accident. It is a good idea, therefore, to check out every number.