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Federal Housing Administration (FHA) loans require escrow accounts for the payment of property taxes, homeowner’s insurance, and mortgage insurance premiums (MIP). Rather than paying taxes directly to the government or insurance premiums to the insurer, an FHA borrower pays toward these expenses each month as part of his mortgage payment, with that money placed in an escrow account.
The proceeds from this holding account are used to pay the tax and insurance bills when they come due.
Key Takeaways
- An FHA loan is insured by the Federal Housing Administration and provided by an FHA-approved lender, made available to lower-income individuals and those with lower credit scores.
- Escrow accounts are custodial holding accounts for money deposited each month by the mortgage loan borrower.
- In an FHA loan, funds from the escrow account are used when property tax and insurance payments come due.
- FHA requires borrowers to pay mortgage insurance premiums when the down payment at the time of home purchase is less than 20% of the appraised value of the home.
How Escrow Accounts Work
A Federal Housing Administration (FHA) loan is a type of mortgage loan issued by an FHA-approved lender and insured by the FHA. These loans are designed primarily for low or moderate-income borrowers and require a lower minimum down payments at the time of purchase.
In addition, compared to traditional loans, FHA loans are more lenient in terms of acceptable credit scores (as low as 500). Importantly, the loans are not provided by FHA, but rather are offered through FHA-approved lenders, such as a bank, and the FHA guarantees the loan.
An escrow account serves as a holding account managed by the lender, from which the property tax, the homeowner’s insurance, and the MIP payments are made on the home owner’s behalf. Each month, in addition to the principal and interest payment, the homeowner pays an estimated one-twelfth (or one month’s worth) of the yearly tax, insurance, and mortgage insurance payments.
The escrow account holds this money until the bills come due. Each year, the monthly escrow payments for the following year are adjusted up or down based on whether there was a shortage or surplus in the account for the current year’s payment.
Mortgage Insurance Premiums
MIP is a type of private mortgage insurance (PMI) specific to FHA mortgages. The FHA requires a borrower to pay MIPs when the down payment on a home is less than 20% of the value of the property.
These premiums pay for an insurance policy that protects the lender in case the home is foreclosed on, and the lender cannot recoup the outstanding loan balance in full. Thus, with a lower initial down payment, there is less equity in the property and a greater need for MIPs.
An FHA borrower can stop paying MIP premiums when the loan balance is reduced to 78% of the home’s appraised value (at the time of purchase). In a situation where the property gains sufficient equity through value appreciation, the homeowner can apply to have MIPs removed if equity is over 20% of the current appraised value and previous mortgage payments have been made in a timely manner.