What Is Escrow Reconciliation and How Does It Work?

Escrow reconciliation, also known as an annual escrow analysis, is a yearly review of your escrow account by your mortgage lender. Each year, your lender examines the account to ensure the amount you contribute is sufficient for the anticipated costs of property taxes and insurance. This process involves a detailed look at past payments and projections for future expenses to align your monthly payments with actual costs.

The Purpose of an Escrow Account

An escrow account is a savings account managed by your mortgage lender to pay for property-related expenses. When you make your monthly mortgage payment, a portion is directed into this account. The funds are then used by the lender to pay your property tax bills and homeowners insurance premiums when they become due, breaking down large bills into smaller monthly installments.

Lenders establish these accounts to protect their financial interest in the property. By ensuring that property taxes and insurance are paid on time, the lender mitigates risks such as tax liens or property loss from uninsured damage. In addition to property taxes and homeowners insurance, escrow accounts can also pay for private mortgage insurance (PMI) or flood insurance. Some loan types, like those from the Federal Housing Administration (FHA), require an escrow account.

The Annual Escrow Analysis Process

Each year, your mortgage servicer conducts a review of your escrow account, a process governed by the Real Estate Settlement Procedures Act (RESPA). The analysis begins with a look back at the previous 12 months of account activity. The servicer reviews the total amount paid into the account versus the actual disbursements made for property taxes and insurance premiums.

Following the historical review, the lender projects the funds needed for the upcoming 12 months based on the most recent tax bills and insurance premium statements. If your local taxing authority has increased property taxes or your insurance provider has raised your premium, these new amounts will be used to calculate your future payments. This ensures enough money will be available for the next cycle.

A component of this calculation is the “cushion” or “reserve,” which is also regulated by RESPA. This law permits lenders to maintain a buffer in your escrow account to cover unexpected increases in costs. The maximum cushion allowed is one-sixth of the total estimated annual disbursements, which is equivalent to two months of escrow payments. This buffer ensures that funds are available if a bill comes in higher than anticipated.

Understanding the Escrow Statement Outcomes

After the annual analysis is complete, you will receive an escrow analysis statement detailing the findings. This statement will reveal either an escrow shortage or a surplus. A shortage means the analysis projects that your account will not have enough funds to cover the upcoming tax and insurance payments plus the required cushion. This often occurs when property taxes or homeowners insurance premiums have increased more than anticipated.

Conversely, a surplus means there is more money in the account than necessary to meet the projected obligations and the required cushion. This can happen if your property taxes went down or if you switched to a less expensive homeowners insurance policy. The escrow analysis statement will outline the calculations, showing the projected disbursements, the required cushion, and the resulting shortage or surplus amount.

Responding to a Shortage or Surplus

If the escrow analysis reveals a shortage, you generally have a couple of options for repayment. The most common approach is for the lender to automatically spread the shortage amount over the following 12 months, adding it to your new monthly mortgage payment. This increases your total monthly payment but avoids a large, immediate outlay of cash. Alternatively, you have the option to pay the shortage in a single lump sum.

When the analysis results in a surplus, the lender’s course of action is guided by RESPA regulations. If the surplus amount is $50 or more, the lender is required to send you a refund check, typically within 30 days of the analysis. If the surplus is less than $50, the lender has the option to either refund the money or apply it as a credit to your escrow account, which would slightly lower your monthly payments for the next year.