With one important exception, lenders price loans on the assumption that borrowers will include taxes and insurance premiums in their monthly mortgage payments. These payments are placed in an escrow account under the lender’s control. On a payment date, the amount due is paid by the lender.

The escrow requirement protects the lender. If the taxes are not paid, the tax authority could place a lien on the property that would have a higher priority than the lender's lien. Similarly, if the insurance premiums are not paid and the house burns down or is flooded away, the lender's protection goes with it.

Escrow is not an absolute requirement. Borrowers who want to pay their own taxes and insurance can waive the requirement by paying a modest fee. Most borrowers offered the choice accept the escrow, I suspect less to save the fee than because they find that the payment discipline is useful. I escrowed on both my mortgages because it simplified my life.

Sub-Prime Loans Usually Don't Carry Escrows

In the sub-prime market, however, most borrowers are not offered the choice. They need not pay a fee to have the requirement waived because there is no requirement. In this market, loans are sold to relatively unsophisticated borrowers on the basis of payments, which are lower when they don’t include escrows. Lenders who insisted on escrows would lose business to those who didn’t.

The upshot is that borrowers who have shown themselves to be the least capable of managing their credit affairs, who are most in need of the discipline provided by the escrow system, don’t have it offered to them.

With the recent jump in sub-prime foreclosures, this feature of the sub-prime market has emerged as one contributor to the problem. Legislators hearing about it are understandably outraged. The response of some is to propose that escrows be mandated by law on all mortgages.

Mandating Escrows Carries Risks to Borrowers

In deliberating this idea, lawmakers should understand that the firms who manage escrow accounts, call them "servicing agents", or SAs, sometimes abuse borrowers for profit. SAs are not selected by borrowers, and cannot be fired by them no matter how much harm they cause the borrower. Further, when SAs manage a borrower’s escrow account, the potential harm they can cause increases substantially.

For one thing, SA systems sometimes fail and the borrower’s tax and insurance payments don't get made. (See Advantages and Disadvantages of Mortgage Escrows). Because some SAs don’t disclose the payments they make, or don’t make, on a current basis, borrowers can be in the dark for an extended period before they discover that the SA has screwed-up. (See Should All Borrowers Receive Monthly Statements). Meanwhile, they may find themselves with a cancelled insurance policy or a tax lien on their property.

I have heard many horror stories of this type directly from borrowers. Outside of legal action against the SA, which few borrowers can afford, they have no effective recourse. Borrowers who pay a fee to waive escrows often do it to avoid this risk.