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How Escrow Accounts Work

What is an escrow account?

Wikipedia defines it this way:

Escrow generally refers to money held by a third-party on behalf of transacting parties. It is best known in the United States in the context of real estate (specifically in mortgages where the mortgage company establishes an escrow account to pay property tax and insurance during the term of the mortgage).

So, how does it work?

When a home purchase closing commences, the settlement agent or title agent will review the closing disclosure with the home buyer.  On the closing disclosure will be a detailed review of the funds being collected for “prepaid items” and a detailed view of “initial escrow funds paid at closing.”  The difference is prepaids are funds the title agent will disburse to third parties after closing and escrow funds start your escrow account.  Prepaids include interest for the remainder of the month, the first year of home insurance premiums (due upfront), and any property taxes being paid out to the county at time of close.

Your home insurance agent will want the first year premium at time of close.  You will bring this along with your other funds needed at closing, and then the title agent will pay your insurance from those funds.  It is also an option to pay the first year insurance premium before closing and then provide the lender/creditor with the paid in full insurance binder.

What is an aggregate adjustment?

Another line on the closing disclosure is “aggregate adjustment” which is a deduction from the total initial escrow account.  The initial escrow funds calculation for property taxes and insurance are done on a set number of months, depending upon a few criteria:

  • The month in which the loan is funding
  • The first payment date
  • When property taxes and insurance are next due

The calculation is done to keep the escrow account above $0 for the entire next year, but as close to $0 as possible.  Rules govern the amount of funds a creditor can hold in escrow, thus the aggregate adjustment is a line that balances out the account to bring the initial balance to just the right amount with a small amount of extra reserve.

With an established initial escrow account and  adding to it each month as part of mortgage payments, future taxes and insurance will be paid.  The title agent will put enough in there so it has just enough to pay the future property taxes and insurance premiums.  Typically one of the closing documents will be the escrow account agreement, and shows the monthly amount being collected and future disbursements.  It is still the home owner’s ultimate responsibility to insure the account has enough funds.  If property taxes or insurance increase, the annual escrow review from the loan servicer will have options to pay the shortfall in a lump sum or add it to future payments.  Then, of course, the monthly escrow payment will also increase to cover the future property taxes and insurance.

Benefit of escrowing property taxes and insurance:

Escrow accounts offer convenience and peace of mind.  In Minnesota, counties collect property taxes twice per year in May and October.  These are easy to miss if paid outside of an escrow account and then penalties get assessed.

 

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Financial Considerations When Selling Your Home

Selling your home is a major step in life.  The reasons for selling are as varied as real estate itself.  The reason(s) for selling generally outweighs the cost, but how does one evaluate all the costs?  We immediately think of the tax consequences, the Realtor fees and the price for a new home, but let’s not leave out the details.  This article will explore many other financial considerations when selling your home.  It might be a good idea to make a list of any of these items that might apply to you:

Tax Benefits/Consequences

What tax benefits?  Consider the current amount of interest, property tax and any mortgage insurance currently being paid.  These are all tax deductible items now.  If your new home carries a higher amount of any of these, that will add to your schedule A itemized deductions (new mortgage may be $100 more, but take away $x of that for the increased tax deduction).  Your new home may be currently lacking utilities and/or appliances, or in need of replacement (thinking of you, fixer uppers).  New appliances and utilities can have energy tax credits that you can deduct on your federal income taxes.  Think about tax assessments – do you live on an old street that may be coming up for replacement?  Is your association starting to talk about a new roof on the building?

Capital Gains Tax

Always be concerned with capital gains, but know when it applies.  This is where a good CPA comes in handy.  Often capital gains tax doesn’t apply when selling your personal residence, but not so fast with investment property or inherited property.  Schedule a time with your tax professional before listing your home.

Utilities

Newer homes are generally more energy efficient due to technology in construction and appliances.  In Minnesota, we think of utility costs in regards to electricity in the summer and heating fuel in the winter.  Consider the age of your appliances, your current energy bills and how a potential buyer might look at those in evaluating their home options.

Maintenance

Going from a townhome to a 1/2 acre estate?  Consider what your current maintenance expenses are compared to what they will be.  Some people sell their home to not have maintenance anymore.  Aside from the work, maintaining certain systems can be expensive.  If your home has a pool, wood siding, aging appliances, or other features that have upcoming maintenance a buyer will notice (or their inspector will).

Property Taxes

We touched on this earlier, but more than assessments or income tax implications, property taxes can vary greatly from property to property and city to city.  Look at the property tax amount on your home compared to other homes around you for sale.  How does it compare?  How do the taxes on your home compare to the taxes on new prospective homes?

Home Insurance

Premiums are based on a variety of factors, some concern your personal credit and other policies bundled in, but many factors regard the features of the property.  A new roof, proximity to fire stations, having a sump pump and generally new construction will have lower premiums.  Wood fireplaces, pools, older homes, aluminum siding, outdated electrical systems, visibility from the road, no garage,  and other factors can drive premiums higher.  Talk with your insurance agent about how your premiums might change from the old to the new.

Stress and Finances

Selling a home is stressful, of course, but did you think about how that translates into your finances?  Stress can lead to “comfort spending” – that extra mocha or dinner out, spa visits, yoga class or a getaway just to help you cope with this process should go into the transaction expense.

Moving Expenses

Add in the truck, boxes, blankets, Paul and Roger (the two moving guys), fuel, tape, set up fees, take down fees, and did we consider the piano?

Current Interest Rate Environment

The market has changed since your bought your home, or completed your last mortgage.  Consider the differences in the market compared to what terms are on our current financing.  You might have to let go of that 30 year fixed at 3.25% you have and accept the current interest rate for what it is.

Selling Expenses

This is where we discuss Realtor costs, mortgage payoff, and title costs.  We won’t get into the different commission structures or fees, but rather to just consider the expense.  Your professional Realtor can cover all of these with you by reviewing a “net sheet,” which illustrates a breakdown of how your sales price translates to your bottom line net proceeds.  The Realtor expenses (includes commission and broker admin fee), deed tax, title closing, recording fees, mortgage payoff (includes interest through payoff date), and prorated property taxes are all subtracted from the sale price.  Also subtract any seller paid closing costs for the buyer, but this isn’t actually an expense.  It should be deducted from the sale price and the net of the two considered the actual sales amount.  The buyer is essentially “financing in” their costs to obtain a loan.  As a seller, look at the net sale price after seller concessions.

Buying Expenses

When buying a home the closing costs for title, mortgage loan, appraisal, inspection, recording of the deed and mortgage, and broker admin fees all apply.

Home Search Expenses

I know your first thought – “We can find our home online, right from our living room.”  We don’t buy houses this way, or at least most of us don’t.  Unless your Realtor is driving you from point A to B, add in the fuel and wear and tear on your vehicle.  Also keep in mind your time spent and the possibility of having an inspection completed on a new potential home only to find a serious issue and having to start over.

Opportunity Cost

Ever heard the story of the poor sap who sold his farm that laid upon an oil field, only to be discovered by the next owner?  If you live in an up and coming area, consider the cost of selling your home now just before the neighborhood booms!

Did we miss something?  Send an email to sfurlong@muihomeloans.com and we’ll add (or “price”) it in.  Thanks for reading!

 

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Should I Refinance?

TO REFINANCE OR NOT TO REFINANCE?

That is the question, but how to find the right answer?  First things first – have your goals together.  Mortgage Lenders are great at putting together loan options, but they are often times basing those options on what you tell them.  If you are asking for the lowest rate, they will put those options in front of you, but surprisingly they may not always be the best options.  Wait!?  What, the lowest rate isn’t always the best option?  Of course not – considering that the lowest rates are adjustable, or shorter loan terms with payments that may be out of reach for you.  So, let’s look at your goals for the refinance:

Number 1: I WANT TO SAVE MONEY!

Everyone likes to save money – we like to save money!  That’s why we’re writing this blog instead of mailing you a letter.  Letters cost stamps!  Let’s be more specific: do you want to save money now, as in lowering your monthly debt payments, or do you want to save the most over the term of the loan?  Are you struggling to make the payments you currently have, or does your end of month surplus cash look like the US Treasury’s?

The best place to start is by looking at your budget.  How much are you spending on all of your debt each month?  Is that a high or low percentage of your monthly income?  Do you have discretionary funds?  Do you have a large amount of unsecured debt?  How did you get to where you are and what changes need to be made to not get there again (if it’s not where you want to be)?  Is your retirement savings on track?  Having the answers to these questions before approaching a refinance is a great idea.  Even better – meet with your financial planner before talking to your lender to help put these answers, and goals, together.  Define what “saving money” looks like for you first.

Number 2: I WANT TO LOWER MY PAYMENTS

Debt isn’t much fun (well, it is for us, but for different reasons than you would think), but what it offers can be great.  Mortgage loans are necessary for most people to own a home.  We think owning a home is great!  Auto loans are generally necessary to finance your transportation.  Student loans – education.  Credit cards?  We’re not much of a fan of these.  Using a credit card for convenience and paying off the balance each month?  That’s generally a good thing.  Credit cards are bridge financing if you carry a balance – the interest is costly and paying the minimum will take forever to pay off the balance.  The point is: carrying the right kind of debt is ok, but eliminating the wrong debt is essential to your financial health.  Sounds like we are talking about cholesterol here and the analogy works: having a mortgage loan is like HDL- your financial health is better with this kind of debt, but high a high credit card balance is like high LDL and puts your finances on the path of systemic failure.  Refinancing offers an opportunity to right the ship, a “statin” for your system.  By eliminating the bad debt and restructuring/lowering your monthly debt payments you can bring your finances to a better place.  But beware – the last thing you want to happen is to combine all of your debt, lower your payments and then go on a spending spree.  It’s important to take full advantage of the opportunity and create a sound financial plan to avoid adding the “LDL” debt again in the future.  If your payments are reduced, plan to put some emergency money away and make sure you can pay off that credit card each and every month for good.

Number 3: I NEED TO FIX OR IMPROVE MY HOUSE

Construction loans, credit lines, fix up funds and often times local money is available in addition to your existing mortgage loan.  Sometimes it doesn’t make sense to refinance your current mortgage just to get some money to put a new roof on the house.  Look at the terms of your current mortgage and what is available from your lender.  If the interest is going up on your current loan by more than what you would save on the construction financing portion, then just add the construction loan instead.  Generally construction financing rates are higher than first mortgage rates, but if you are borrowing a small amount or your current mortgage has a much lower rate, then adding the secondary financing is a better option.  If the construction project is larger, then it might make sense to refinance to a construction loan program like FHA 203k or Homestyle so that you can make the improvements and get a low, fixed rate loan for the project and your current mortgage balance all in one.

Number 4: I WANT TO LOWER MY TOTAL COST

Long term planners – this paragraph is for you.  How much does the rate need to decrease for a refinance to make sense?  If your other debt is in order, and your home is perfect as-is, then let’s look at break even points and a cost-benefit analysis.  The absolute way to compare your current loan to a new loan is how much and how long.  Take your current payment times the remaining term to calculate a total cost on your current loan.  If the refinance option reduces that total number by an acceptable amount, by the same math (how much times how long), and the payment works, then it generally makes sense to do.  Let’s look at an example:

Current principal and interest payment (exclude taxes and home insurance): $1200

Remaining number of payments on your loan: 280

Total cost: $336,000

New 15 year loan principal and interest payment: $1516

New total cost: $272,880

If the higher payment fits into your budget, this certainly makes sense to do if you are looking for long term savings.   Even if the refinance costs $3,000, the savings is about $60,000 over the term.  This is a common scenario right now for many 30 year loans with rates in the mid-4% range to refinance down to a 15 year term.  You should also compare the total cost on your current loan if you simply increased the payment, but generally the refinance will add up to more savings.

The other calculation you need is the break even point.  At what point in the future will I recoup all of the costs of doing the refinance?  Two ways to calculate the break even offer manipulation of this time frame.  One way to calculate break even is on the interest savings.  If you save .625% in interest on the loan (reducing the rate by this much) and the refinance costs 2.375% of the loan amount, then it will take 3.8 years to recoup (ignoring time value of money and the decreasing benefit of interest savings over time).  If you are a spreadsheet guru you could put this into an amortization table and calculate the exact break even by interest savings, but hey, life isn’t exact anyway.  The other way to calculate break even is on a cash flow basis, but this isn’t as effective a calculation.  If the monthly payment savings is $300 and the loan costs $6,000, then it will take 20 months to break even.  The reason this approach is flawed is that you might be extending the term on your loan for this payment savings, which would potentially cost more in the long run.  The simple formula here is: cost divided by benefit.  That will yield the break even point.  Have your lender help, and if they don’t know how to calculate this for you, then find a different lender!

Number 4: I WANT TO REDUCE MY TAX BILL

Mortgage interest is tax deductible.  If you consolidate other debt that doesn’t have tax deductible interest, you could reduce your overall tax liability.  Bring in your CPA and let’s have coffee with calculators.  It’s great fun, and so is saving money!  We think the government has enough to work with anyway, so why give Uncle Sam more than he has contracted for?

Number 5: I STILL DON’T KNOW WHAT TO DO

This likely has been more fun for us to write than for you to read about it.  We are only going to complete a refinance for you if it makes financial sense to do so.  Sure, completing loans is fun, but we need to make sure it is to your benefit.  MN State law requires that the loan have benefit for you, and we’re you’re fiduciary, which means we need to look out for your best interests (no pun intended!).  Bring your questions and scenarios to us and we’ll crunch numbers, calculate the savings, project long term costs, ask CPAs for tax analysis, talk with financial planners about retirement and other savings goals, and have you leaving our office more confident in your financial future.  Maybe then you can spend more time working on getting that LDL lower instead of worrying about making extra payments on that credit card that seems to be stretching out to infinity.

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Conventional Mortgage Insurance Options

About Mortgage Insurance

Private mortgage insurance is required for borrowers of conventional loans with a down payment of less than 20% of the purchase price. Mortgage insurance is an insurance policy for the lender that provides coverage to the lender in the event that the borrower is unable to repay their mortgage.

There are several options for paying the premium:

  • Monthly Premium: The borrower pays the same amount every month until the loan balance is paid down to 78% of the initial property value, at which point the mortgage insurance payments end. There is no initial premium at closing.
  • Single Premium (Refundable): The borrower makes one lump sum payment at closing, but receives a partial refund if the loan is terminated within 5 years. There are no monthly payments.
  • Single Premium (Non-Refundable): The borrower makes one lump sum payment at closing. There are no monthly payments.
  • Single Premium (Lender Paid): The one-time lump sum payment is paid by the lender through a higher interest rate for the borrower.
  • Split Premium: The borrower pays a portion of the premium upfront and a portion in monthly payments.