Whether you are purchasing a new home, refinancing as a method of loss mitigation, or doing a cash-out refinance to pay off debt, at some point you will have to make a decision about impounds.
What are Impounds?
Impounds, or escrows outside of California, are basically a forced savings account that your mortgage lender sets up for you, in order to pay your property taxes and homeowners insurance. They make those payments for you, from money you pay with your mortgage every month. If you’ve ever had a property tax come due, and not had the cash to pay it, an impound account might be a wise idea. If your loan has a 90% or greater LTV (loan-to-value ratio), California lenders require such an account.
Advantages and Disadvantages of Impounding
The advantages of impounds all have to do with making it easier to budget. In California, property taxes are late on December 10th (just before the holidays) and April 10th, just as income taxes are due – not having to plan for a large payment at those times is much easier for average homeowners, who may sometimes live paycheck to paycheck.
With homeowners insurance impounded as well, you get the benefit of a monthly payment, without your insurance company tacking on a convenience fee for allowing it.
If you own a second home, or rental property, setting up an impound account may make accounting easier, as you’ll be factoring in the same payment from month to month. With rental properties, especially, it makes it easier to set rental rates that will meet the expenses of the property.
Impound accounts can also protect you from sudden changes in market conditions. In an article in the Los Angeles Times on Sunday, April 1st 2007, real estate journalist Kenneth R. Harney gave an example of a couple who had a sub-prime home loan, one of the 2/28 ARMs that are so much in the media this year. Sub-prime lenders generally don’t offer impound accounts, and if they do offer them, don’t require them. This is done with the intent of keeping mortgage payments relatively low. In Harney’s example, however, he speaks of a colleage who:
“…recently refinanced a young married couple on the verge of foreclosure. They had bought their first house in 2004 with a “2/28” sub-prime adjustable rate loan at 7%. With no escrow account, the monthly payment was just $703. After the first two years, their payment jumped to $857.”
That may not seem so bad, but this couple didn’t have an impound account, and compounding their problems was the fact that their insurance company went out of business, leaving them with no coverage.
What happened next is fairly typical of the industry. As the article states, “Their lender then ‘force placed’ substitute insurance costing $1,700 a year, nearly double the $900 premium they’d had before. Also, because they hadn’t been able to pay their property taxes, the lender paid, leaving the couple owing an additional $5,000.” And then what? Well, in order to recoup the money spend on taxes, “…the lender increased their monthly payments to $1,646,” which was significantly more than what the couple could afford. If this couple had impounded just their taxes, they would have had a month to find new insurance, and could have approached a refinance from a much more relaxed position.
As Harney pointed out, the lack of required impounds on subprime loans is a significant factor in the current state of the mortgage industry. Says Mike Calhoun, president and COO of the Durham, North Carolina-based advocacy group the Center for Responsible Lending: “It’s an upside-down world. The people you’d think need an escrow the most aren’t required to have them, and the people who need them the least are forced to use them.” Clearly, for some people lack of impounds is the equivalent of a string of car accidents.
As for the disadvantages of impounding, there largest one is: if you are financially stable enough to not have to budget, but can leave the equivalent of your tax payments in a bank or investment account, you’ll earn interest on the money. Another point against impounds is that you don’t have control over the funds – the bank does.
Still, lack of control of a few thousand dollars seems a small price to pay for the knowledge that your taxes and homeowners insurance will never be late. It’s also important to remember that these payments are factored into your qualifying ratios when you apply for a loan. The “TI” in “PITI” stands for “taxes and insurance.”
The bottom line: even if your lender doesn’t require impounds of taxes and insurance, you should do it anyway. Then you can move on to worrying about more important things, like where to get the best auto insurance quote for your car.