When I talk to soon to be first time home buyers I normally ask what monthly payment feels comfortable. Typically they have been on various websites figuring principal and interest payments so they have an idea of what they think the payment will buy. I always ask if they have included property taxes and insurance in their payment comfort level. The responses are about 50/50 whether or not they have considered taxes and insurance. Using current interest rates a payment of $575 principal and interest will buy you a home priced around $115,000 using a conventional loan. So if you were just factoring in the principal and interest payment and you felt $575 was a comfortable monthly mortgage payment you would conclude that $115,000 would be a price range that would work for you. However, if I told you that the payment on that home would more likely be $760 once you factor in the taxes, insurance and mortgage insurance that price might not be so attractive.
Unless a borrower is putting at a minimum 10% down, the lender will require what is known as an escrow-which consists of 1/12th of your property taxes and 1/12th of homeowner's insurance and a certain percentage of what is known as mortgage insurance in your payment.
Two things a lender always wants paid on time are property taxes and hazard insurance. The reason the lender wants property taxes paid is that any unpaid taxes represent a lien on the property that will be paid prior to the lender being paid in the event of a sale or foreclosure. It should go without saying why the lender wants the hazard insurance paid since the lender has the biggest financial stake in the property, they have no interest in taking the chance that the insurance will lapse. So the system of taking the insurance in your monthly mortgage payments insures that it will be paid on time.
Monthly mortgage insurance is placed on any mortgage in which the buyer has less than a 20% equity stake in the home. In other words, the value of the property must be 20% higher than the mortgage if mortgage insurance is to be avoided. Mortgage insurance in reality is there to protect the lender for the portion of the mortgage between 80% and 100% of the value of the property in case of default or a short sale. A lot of buyers feel that mortgage insurance is nothing more than a fee they are tossing down a rat hole every month. I prefer to look at it this way-mortgage insurance is essentially a way of putting 20% down over a lengthy period of time-normally about eleven years before that 20% equity is reached. At that point on a conventional loan the mortgage insurance will come off automatically. While it does seem as if it inflates the payment unnecessarily, it does allow people to purchase homes without having to save the 20% to put down.
In any event, these monies make up what is known as the escrow account. Your escrow account is a non interest bearing account in which the money is set aside on a monthly basis to pay your property taxes, your insurance, and your mortgage insurance when those items are due on an annual or semi annual basis. In many ways this enforced savings plan means that you won't have to slap your forehead when that unexpected insurance bill shows up. Federal law stipulates how much extra money can be in your escrow account at all times. So once in awhile you will receive a check back from your lending servicer that is an escrow overage-meaning the escrow account had accrued too much money. Typically this happens in the cases of new construction when the taxes aren't fully assessed so too much money is taken in to cover taxes. It is more likely that your escrow account will come up a bit short due to increases in taxes or insurance. A small cushion is allowed to cover cost increases, but every once in while it isn't enough. You tax or insurance bill will be paid, however, the lender will then normally give you the option of making up the difference in the shortfall in one payment or a series of higher mortgage payments to catch up.
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