Should you escrow for taxes and insurance?

The conventional wisdom is that the private person, selling their property and taking back a mortgage should not go to the extra trouble of escrowing for taxes and insurance.

After many years experience, we disagree. We have found that many times the real estate borrower will not pay the annual taxes and often will not renew their insurance in time.

The result of the first problem is that if you end up foreclosing the loan, you will have to pay the taxes eventually, for the period when you did not own the property.

Likewise with the hazard insurance. Some borrowers are responsible about this, many aren't. And if the house burns down with current insurance, you, the lender, will be the biggest loser.

So how do you escrow for taxes and insurance? It's easy.

Real estate taxes

First of all, when are the annual taxes payable? In Florida they are due at the end of November for the year just ending. You want to make sure there is enough money in the escrow account to pay the taxes in full when they are due. Let's say  for example that the annual taxes are $1,200. This is $100 per month. The amount you need to collect at the loan closing will depend on where you are in the year. You should aim to have no more than 2 months extra in escrow.

If you close the loan on December 1, and the taxes where paid in full for the previous year when the loan closed, then you only need to collect $200 into your escrow account. Then of course, $100 per month. By the following November 30 you will have all the money you need. Likewise if you close on January 1, you need $300 at closing etc. If you close on October 1, you need to collect $1,100 as the taxes will be due at the end of the next month.

The alternative would be to collect less at closing but then have higher monthly payments for the first year.

Remember, this example is for Florida. The tax due date may be different in your state.

Hazard Insurance

Always make sure you are named as the loss payee. Then if the house burns down, the insurance company knows to pay you first. The same applies to flood insurance, if needed.

Some insurance policies can be paid monthly, and if the borrower is doing that, fine. But don't rely on them having all the money they need if an annual payment is required. In these circumstances, we recommend you escrow every month for 1/12 of the insurance premium and get 2/12 up-front at loan closing.

What to do with the money

We recommend you keep the money in a separate savings account at the bank, called the John Doe escrow (if this is your name). Remember, this is NOT your money, you are holding it on trust for the borrower.

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