Handling Escrow on Your Loans – 1 of 3

The Rules for Lenders

Tracking escrow on mortgage loans is a big deal, and an important part of servicing loans properly.  There are a lot of moving parts to doing it correctly.  What are the rules, how do you track the information about payments you’ve made and will make in the future, how do you decide how much to charge each month so the amount you have in the escrow account is reasonable and legal, what about sending the correct documentation to the borrower and the IRS?  Making a mistake can call into question the validity of your calculations, expose you to fees or penalties, or even put your collateral in jeopardy.

The United States government enacted the Real Estate Settlement Procedures Act (RESPA) in the mid 1970’s to help consumers understand the costs of getting a loan as well as regulate practices that were padding extra fees onto new home loans.  The law also limited how much money lenders could require from their borrowers to keep in an Escrow account.

What the law says is that your lowest balance at the end of any month in a twelve-month period on a mortgage shouldn’t be higher one sixth of the annual expenses to be disbursed.  This means a two-month cushion if all the expenses fall within a single month.  The cushion will be larger if the amounts paid out of the escrow account are scattered throughout the year.

At the beginning of each year, lenders should perform an aggregate accounting for the year using expected payments and expected disbursements from the escrow account to determine the month-end balances.  Each month, starting with the closing balance at the end of the previous month, scheduled payments from the borrower will add money to the escrow account and any disbursements will subtract money out.  After those transactions post, we have the ending balance for the month.  Repeat for each month in the twelve-month period.  That’s the “aggregate accounting” method prescribed for by RESPA.

The IRS requires lenders to send in Form 1098 - Mortgage Interest Statement for all mortgages with $600 or more in interest (including most types of fees) by the end of February if filing on paper, and by April 1^st if filing electronically.  Paper forms must be printed onto official IRS Form 1098 (the red copies) for Filing with the IRS.  Lenders are also required to send copies of form 1098 to their borrowers.  The borrower copies can be substitute forms and are acceptable as long as they have the corresponding information listed in an understandable way.

Up next: Part 2 of the Series – How to do Escrow in Moneylender