Should a Private Note Have an Escrow Account for Taxes and Insurance?

An escrow account, also called an impound account, collects a monthly amount from your payer for property taxes and insurance and pays those bills when they fall due. A private note does not need one to be valid or saleable, but an escrow run by a servicer removes one of the questions a buyer prices, and it protects the property behind your note while you hold it.

Most bank mortgages have an escrow. Most seller-financed notes do not, because the seller and the buyer agreed at closing that the buyer would pay the taxes and insurance directly. That arrangement works until the year it does not. Here is what an escrow does, how it bears on what your mortgage note is worth, and whether it is worth adding to a note you already hold.

How an escrow works

The yearly property tax bill and the yearly insurance premium are added together and divided by twelve. That amount is added to the monthly payment. The money goes into a separate account, usually held by a loan servicer, and the servicer pays the county and the insurer from it when the bills arrive.

An illustrative payment

Illustrative figures. Your note’s payment, tax bill and premium will differ.

Taxes and premiums change, so the servicer reviews the account once a year, compares what came in with what went out, and adjusts the monthly amount. A shortfall is usually collected over the following year. A surplus is refunded or credited. Many servicers also hold a small cushion so a higher bill does not leave the account short.

The $300 and $150 are not income to you. They belong to the payer until they are spent on the payer’s bills, which is one reason to let a servicer hold them in a separate account instead of depositing them with your own money. Some states have rules on escrow accounts, including in some cases a duty to pay interest on the balance, and federal escrow rules under RESPA and Regulation X govern many residential loans. Whether those rules reach a private note depends on the loan and the holder, so ask the servicer or an attorney.

Why buyers care about taxes and insurance

Unpaid property taxes generally become a lien that ranks ahead of your note, whatever the date of your mortgage or deed of trust. A lapsed insurance policy leaves the building, often most of the security, exposed to a single fire or storm. Either one can wipe out equity a buyer was counting on. When it happens on a note with no escrow, you find out late, which is why the pages on a borrower who has not paid the property taxes and a borrower who let the insurance lapse exist.

A buyer checks both before funding. They pull the county tax record, ask for the insurance declarations page and confirm the holder is named as mortgagee. On a note with no escrow, they also ask a forward-looking question: who makes sure this keeps happening after I buy it? The checks themselves are set out in due diligence before funding.

How an escrow affects the price

An escrow does not change the rate, the balance or the term, so it does not rewrite the math of the note. What it changes is the risk a buyer sees, and risk is what sets the return they ask for.

• A note with an escrow run by a professional loan servicer, and a record of the bills being paid from it, gives the buyer a documented answer to the tax and insurance question.
• A note without one, but with a payer who has paid both on time for years and can show it, is in a similar position. The proof is simply in a different place.
• A note without an escrow and with a recent tax delinquency or lapse is priced with that history in mind, and some buyers will want an escrow set up as part of the purchase.

We will not put a percentage on the difference, because it depends on the property, the payer’s record and the buyer. In most deals an escrow matters less to the price than the payment history or the equity, and more to how many buyers are comfortable bidding. To see where your note stands as it is, send us the details, including whether taxes and insurance are current.

Adding an escrow to a note you already hold

Start with your documents. Many mortgage and deed of trust forms include a clause that lets the holder require escrow payments, sometimes waived at closing but able to be reinstated. Others say nothing, and then an escrow can only be added with the payer’s written agreement. A land contract may be different again.

1. Read the taxes, insurance and escrow sections of the mortgage, deed of trust or contract.
2. Ask a loan servicer whether it can set up and run an escrow on a private note, and what it charges for that work.
3. If your documents allow it, give the payer written notice with the new monthly amount and the start date. If they do not, ask the payer and put the agreement in writing, with an attorney’s help if anything else in the note changes.
4. Have the servicer collect the first months before the next tax or premium bill falls due, so the account is funded in time.

Payers often accept an escrow more readily than you might expect, since twelve smaller payments are easier to budget than one large tax bill. A payer who has already fallen behind on taxes may welcome it as a way out. A servicer is useful even without an escrow, and what a note servicing company does sets out the rest of its work.

When an escrow is not worth the trouble

On a short note with a few payments left, on vacant land with a small tax bill and nothing to insure, or with a payer who has paid both bills on time for many years and sends you the receipts, the cost and the conversation may outweigh the benefit. In those cases a yearly check of the county record and the insurance renewal does most of what an escrow would. Put both dates in your calendar and keep the evidence, because it is what a buyer will ask to see.

Escrow as part of getting a note ready to sell

If a sale is likely in the next year or two, an escrow set up now builds a record a buyer can read, alongside the other steps in raising the value of your note before you sell. If you plan to keep the note to the end, the case for an escrow rests on protecting the property, not the price. Either way, the taxes and the insurance have to be paid, and the only question is whether you rely on the payer alone to make sure of it.

Related questions