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Did you think that when you stopped renting and started owning your home, you’d finally be done with deposits? Think again. When you buy a residence with a down payment of less than 20%, your lender may require you to make a deposit on your homeowners insurance, private mortgage insurance, any required additional insurance (like flood insurance), and your property taxes. Even if you have a down payment over 20% your lender may still require you to have an impound account.
How It Works
An impound account (also called an escrow account, depending on where you live) is simply an account maintained by the mortgage company to collect insurance and tax payments that are necessary for you to keep your home, but are not technically part of the mortgage. The lender divides the annual cost of each type of insurance into a monthly amount and adds it to your mortgage payment.
Forced Savings
An impound or escrow account is essentially a form of forced savings. Annual property taxes and home insurance premiums can be significant expenses. They are sometimes close to the cost of your mortgage itself depending on where you live. Including these costs in a monthly payment to your lender forces you to save so that these expenses are covered.
Required Mortgage Impounds
Borrowers who make low down payments are considered to be a higher risk by lenders. By having less of their own money in the property their likelihood of default is higher than borrowers with more equity in their homes. In this situation lenders require mortgage impound accounts.
These accounts prevent the state from foreclosing or putting a lien on the property in the event of non-payment of property taxes. An impound account also protects the lender’s investment from major damage by ensuring that homeowners insurance are paid.
Optional Mortgage Impounds
Even if an impound account is not required, one can be elected at the loan signing. But is that a good idea?
On the downside, it’s locking up money that might be better used elsewhere. Not all states require lenders to pay interest on the funds held in impound accounts, and those that do may not pay as much as individuals could earn by investing the money on their own. Not surprisingly, some consumers would rather set money aside in a high-interest savings account, or some other investment.
Further, if the mortgage company does not pay bills—like property taxes and homeowners insurance—when they are due, the homeowner will still be on the hook. Therefore, homeowners should be aware of the due dates for these payments and monitor their impound accounts carefully.
On the other hand: Although the impound account is designed to protect the lender, it can also be beneficial for the borrower. By paying for big-ticket housing expenses gradually throughout the year, borrowers avoid the sticker shock of paying large bills once or twice a year and are assured that the money to pay those bills will be there when they need it.
Monitoring Your Impound Account
Your monthly mortgage statement will probably show the balance in your impound account, making it easy for you to keep a close eye on it. Federal regulations also help borrowers out in this area by requiring lenders to review borrowers’ impound accounts annually to ensure that the correct amount of money is being collected. If too little is being collected, the lender will start asking you for more; if too much money is accumulating in the account, the excess funds are legally required to be refunded to the borrower.
Additional Considerations
The cash amount that fixed-rate borrowers think of as their monthly payment is still subject to change—this is one of the biggest issues with impound accounts. Since homeowners insurance and property taxes can vary, monthly payment amounts can fluctuate, affecting monthly cash flow with little warning.
Required impound accounts also decrease the amount that money borrowers can place in an emergency fund. The lender keeps a little extra in your impound account, in order to ensure the extra cushion needed in order to keep making insurance and tax payments if you stop making your monthly mortgage payments. This cushion is collected when you acquire the loan. Thus, the startup costs associated with impound accounts can increase the amount that cash buyers need in order to purchase a residence in the first place.
Buyers don’t need to maintain impound accounts forever, though. Once sufficient equity (often 20%) in the residence is achieved, lenders can often be convinced to ditch the impound account.
How Do an Impound Account and an Escrow Account Differ?
Impound accounts and escrow accounts are the same. They are referred to differently based on where you live and the lender you use.
What Are the Downsides of an Impound Account?
The biggest downside of an impound account is that you don’t get the option to earn interest on the money in the account if you live in a state where lenders aren’t required to pay you interest on it. An additional downside is a change in your monthly mortgage payment as property taxes and premiums go up, but this change to your budget would still occur without an impound account.
What Are the Upsides to an Impound Account?
The biggest upside to an impound account is forced savings that ensure your property taxes and home insurance premiums are paid on time. If you leave the savings up to yourself and aren’t diligent about budgeting for them you can be faced with a huge bill you’re unable to pay and could lose your home as a result.
The Bottom Line
For many homeowners, mortgage impounds are a necessary evil. Without them, lenders might not be willing to give mortgages to borrowers who can afford only low down payments. The best way to deal with impound accounts is to understand how they work, monitor them carefully—and get rid of them when you can if you prefer to save for these expenses separately.