By Dan Miller, WCI Contributor
Refinancing your mortgage can be one of the smartest financial decisions that you make. Even small changes to your interest rate can save you hundreds of dollars (or more) each month. One of the important things that you need to be aware of is what happens to your escrow account when you refinance. Although refinancing is less attractive in a climate of higher interest rates, it is important to understand the basic concepts. That will make sure that you're ready to go when the time is right.
What Is an Escrow Account?
An escrow account can be any account where money is held for a period of time. In the context of a mortgage, the term escrow account usually refers to an account held by the mortgage servicer for the purpose of paying property taxes and/or insurance. You pay into the escrow account each month (generally with your regular monthly mortgage payment), and then the servicer pays the property taxes and insurance when they are due (every six or 12 months).
Not all mortgages use an escrow account, though some lenders do require it. If your mortgage doesn't have an escrow account, then you will be responsible for paying those larger expenses when they are due. This takes a bit more foresight and diligence to manage, but some homeowners prefer this instead of having potentially thousands of dollars sitting in a lender's escrow account, not earning interest.
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Escrow Account Adjustments
As long as you don't make any changes or adjustments to your loan, you will continue paying into your escrow account each month with periodic (often annual) adjustments. When your escrow account is rebalanced, the lender will look at your current insurance and property tax bills and adjust the amount you pay each month.
It's common for the lender to require a minimum balance in your escrow account. This is often equal to a couple of months' worth of payments. If the balance in your account drops below this minimum amount set by the lender, you may have to pay an additional amount each month until your balance has caught up.
What Happens When You Refinance
When you refinance your mortgage, your new lender will issue you a new loan that will completely cover your existing loan. While you can expect this new loan to pay off the principal amount of your current loan, you might not know that you will be responsible for fully funding the escrow account for your new loan. Depending on the timing of when your taxes and insurance bills are due and when in the year you close on your loan, this could be several months' worth of escrow payments due at closing.
Unlike your actual mortgage, where your new loan will generally pay off your old loan completely, you likely can't use the money in your existing escrow account to fund your new escrow account. Instead, you'll generally have to fully fund your new escrow account at closing, increasing the amount of money you need to bring to closing. Then, you'll receive a check from your old escrow account a few weeks or months later.
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What Happens If You Refinance with Your Current Lender
You may be wondering what happens if you refinance your mortgage but stick with your current lender. In most cases, because you'll be getting a completely separate loan, you'll still have to fund your escrow account and then get a check back a while later. It may be possible for your lender to transfer funds from one escrow account to the other—check with your mortgage officer to see what options might be available.
Managing the Cashflow
The fact that you usually have to fund your escrow fund at closing and only get the money from your old escrow account later is an important distinction to be aware of. Depending on the timing of your refinance and the amount of your taxes and insurance, this could be quite a large amount. Knowing that you may have to bring several thousand dollars more to closing can help you as you plan your refinance.
The Bottom Line
Escrow accounts are commonly used by lenders to pay the property tax and insurance amounts on homes. Borrowers pay a set monthly amount into the escrow account each month, and then the mortgage servicer pays the taxes and insurance when they are due. When you refinance, it is typical that you will have to fund your new escrow account completely out of pocket at closing. You'll then get a check for the balance of your old escrow account a few weeks or months after closing.
Depending on how much your property tax and insurance bills are and when they are due as compared to the time of year that you are refinancing, this could be a significant amount. Making a plan beforehand can help avoid the uncomfortable surprise where you are scrambling to find sufficient funds to bring to closing.
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