With one important exception, lenders price loans on the assumption that borrowers will include taxes and insurance premiums in their monthly mortgage payments. These payments are placed in an escrow account under the lender’s control. On a payment date, the amount due is paid by the lender.
The escrow requirement protects the lender. If the taxes are not paid, the tax authority could place a lien on the property that would have a higher priority than the lender’s lien. Similarly, if the insurance premiums are not paid and the house burns down or is flooded away, the lender’s protection goes with it.
Escrow is not an absolute requirement. Borrowers who want to pay their own taxes and insurance can waive the requirement by paying a modest fee. Most borrowers offered the choice accept the escrow, I suspect less to save the fee than because they find that the payment discipline is useful. I escrowed on both my mortgages because it simplified my life.
In the subprime market, however, most borrowers are not offered the choice. They need not pay a fee to have the requirement waived because there is no requirement. In this market, loans are sold to relatively unsophisticated borrowers on the basis of payments, which are lower when they don’t include escrows. Lenders who insisted on escrows would lose business to those who didn’t.
The upshot is that borrowers who have shown themselves to be the least capable of managing their credit affairs and who are most in need of the discipline provided by the escrow system don’t have it offered to them.
With the recent jump in subprime foreclosures, this feature of the subprime market has emerged as one contributor to the problem. Legislators hearing about it are understandably outraged. The response of some is to propose that escrows be mandated by law on all mortgages.
In deliberating this idea, lawmakers should understand that the firms who manage escrow accounts, call them “servicing agents,” or SAs, sometimes abuse borrowers for profit. SAs are not selected by borrowers, and cannot be fired by them no matter how much harm they cause the borrower. Further, when SAs manage a borrower’s escrow account, the potential harm they can cause increases substantially.
For one thing, SA systems sometimes fail and the borrower’s tax and insurance payments don’t get made. Because some SAs don’t disclose the payments they make (or don’t make) on a current basis, borrowers can be in the dark for an extended period before they discover that the SA has screwed up. Meanwhile, they may find themselves with a cancelled insurance policy or a tax lien on their property.
I have heard many horror stories of this type directly from borrowers. Outside of legal action against the SA, which few borrowers can afford, they have no effective recourse. Borrowers who pay a fee to waive escrows often do it to avoid this risk.
A second risk arises in connection with an increase in the required escrow payment, which the borrower, for any number of reasons including lack of proper disclosure by the SA, fails to make. Many SAs in this situation place the entire payment in a suspense account and mark the borrower delinquent. This pernicious practice results in unnecessary delinquencies and late payments, and can lead down a slippery slope to collections and ultimate foreclosure.
Unfortunately, to make escrows the norm in the subprime market requires that escrows be made mandatory for all mortgage borrowers. Escrows can’t be required for “subprime” loans only because that term can’t be precisely defined. And if the law only required that escrows be “offered” to borrowers, it would be sabotaged by loan officers and mortgage brokers.
But the requirement could be short. Its purpose is to force borrowers at the outset to confront their ability to afford the major expenses of home ownership, and this purpose would be served by an escrow requirement that applied only to the first year. After that, borrowers should be allowed to opt out if they want to.
But to require borrowers to escrow, even if only for a year, without protecting them against escrow abuses by SAs, would be irresponsible. SAs should be required to provide easy-to-understand monthly statements showing everything that transpired during the month that affected the borrower’s account. This should include payments out of and credits to escrow, balance changes and their sources, rate adjustments, and fees. In addition, SAs should be prohibited from placing scheduled payments of principal and interest in suspense accounts when only the escrow payment is short.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.