What is escrow?
Maybe you've heard the term before, but don't know exactly what escrow is. Escrow is a third-party service that makes it easier for you to pay homeowners insurance and property taxes. Instead of writing a check every month or every year to pay these bills, the money is held by a third party and then automatically.
Typically, escrow is agreed upon by both the buyer and the lender at the time of sale. It is a legally binding agreement that prevents all sorts of bad situations from happening—deals falling through, taxes going unpaid, etc.
It's also used to secure a deal on a home. By putting money in escrow, a potential homebuyer shows the seller that he or she is serious about purchasing. This, called an "in good faith" move, prompts the seller to take the home off the market.
Why people use escrow
Most people don't mind using escrow, as it simply makes their life easier. But there are other benefits of escrows besides paying your taxes and insurance bills.
For example, escrow protects you during the homebuying process. By putting money into a neutral third-party account, you can close a deal with a buyer without having to give a person you don't know money. Escrow agents take a fee from this, of course, but it's better than being backstabbed and losing your deposit.
Another benefit is lower interest rates. Lenders reward users for signing on for escrow, as it protects them in the long run as much as it protects you. Lower risk leads to a better deal and could provide mortgage relief.
Some people also turn to escrow when they refinance.
What happens when you refinance?
Refinancing a home can lower monthly mortgage payments or reduce interest rates, which could save you tens of thousands of dollars over the course of a loan. But some lenders require you to enter escrow as part of the transaction.
In most cases, refinancing is only available after a homeowner has paid off a certain percentage of their mortgage. With more equity in your home, you can acquire a lower sum of money and distribute it over more years, which lowers your payments.
The major difference with an escrow when you refinance comes down to who you're taking a new loan from. If it's the same lender, your escrow account may never change. But if it's not, you'll have to close the old escrow account and start a new one.
Why does this matter?
As any homeowner will tell you, there are more fees associated with purchasing property than just the mortgage. This is where your closed escrow account could become a factor.
There's typically a delay when you close an old escrow account. After some time, you'll receive a check for the balance you've already paid into the account. This means you may not have access to these funds and need to fund your new escrow account before you receive the check.
It is, in most cases, not possible to apply old escrow funds to a new account. The only time you won't have to close and open a new one is when you refinance through the same lender.
How long does the process take?
For most cases, 30 to 45 days is a good guideline, although it could be quicker if the home is sold for cash. That's how long it takes for your old lender to close your escrow account and issue you a check.
Definitely consider the time of year when you consider refinancing a loan. If it's later in the year, your lender may require a substantial amount of taxes to be paid upfront when you refinance.
Because you won't have access to the escrow check for 4 to 6 weeks, you may have to make that payment out of your savings to close the deal.
Opting out of escrow
Opting out of escrow might help lower closing costs or the amount you need to sign off on a refinancing deal. This is because you'd need fewer funds to pay taxes up front for the part of the year that's already passed.
However, some lenders won't do refinancing deals without an escrow agreement. This is almost certainly the case if you've paid less than 20 percent of your current mortgage. Others, because the risk they take on is higher, will have to offer you a new (usually higher) interest rate.
To weigh the pros and cons, look at how much money you would save upfront by opting out of escrow. Compare that to making monthly payments, along with the additional amount you'll pay in interest each month. Then only proceed is that number seems worth it.
Escrow when you refinance
Understanding the ins and outs of escrow when you refinance is important. Ultimately, escrow offers a lot of benefits for homebuyers and simplifies the ongoing process of owning your home.
But there are some instances where opting out could make more sense, especially if it will save you money by locking you into a better interest rate. The key to making the right choice for you is to weigh the long-term financial ramifications of opting out or staying in.
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