Mortgage escrow monthly reserve:
formula and worked example

What a mortgage escrow reserve does

Where a lender collects an escrow or reserve account, each monthly payment includes an extra amount toward the property's tax and insurance bills. The lender holds the money and pays the bills when they fall due. The borrower avoids a large lump sum, and the lender makes sure the property stays insured and free of tax arrears.

The arrangement is common in some countries and absent or optional in others, so check whether your loan uses one. Where it does apply, the reserve is a real part of your monthly cost and is separate from the interest and principal on the loan.

The formula: annual tax plus insurance, divided by twelve

Add the yearly property tax and the yearly insurance premium, then divide by the twelve monthly payments.

• Annual tax: the property tax you expect to be billed for the year, in currency.
• Annual insurance: the premium for building or homeowner cover for the year, in currency.

If the bills are paid on different schedules, such as tax twice a year and insurance annually, the sum is still the right base because it is the total you must fund across the year.

Not every cost is included. Where the property also carries association dues, maintenance charges or flood cover that the lender collects, those can be part of the reserve too, and so the monthly figure on your statement may be larger than the sum of the two bills used here. The formula remains the same: add every annual item the lender collects and divide by twelve.

Worked example: 48,000 tax and 18,000 insurance

1. 1Add the annual bills: 48,000 + 18,000 = 66,000.
2. 2Divide by twelve: 66,000 / 12 = 5,500.
3. 3Share of tax in the reserve: 48,000 / 66,000 is about 73%.

The 5,500 is added to every monthly payment, which means the real outflow is the loan instalment plus this amount. Budgeting from the instalment alone understates the commitment.

Reading the reserve in a monthly budget

Think of the reserve as a fixed cost attached to the property, whatever the loan rate. A lower interest rate may reduce your instalment, but it does nothing to this amount. When comparing two properties, tax and insurance can differ enough to change the monthly cost even if the loans are the same size.

Some lenders keep a small cushion above the exact monthly figure to guard against a rise in the bills. If you see a reserve that is slightly higher than the formula gives, the cushion is the likely reason; ask for the lender's analysis, which should itemise the bills.

• Review the account each year, since both bills change.
• A surplus above a limit may be returned or credited, depending on local rules and your lender.
• A shortfall is often spread over the next year's payments.

A reserve also matters at the beginning. Lenders commonly ask for several months of reserve to be funded at closing so that the first bills can be paid on time, which is a one-time cash need on top of the deposit. Knowing the monthly figure lets you estimate that amount: three months of 5,500 is 16,500.

If your cover is changed mid-term, perhaps to a higher sum insured after renovations, update the lender promptly. The reserve then adjusts at the next analysis rather than being surprised by a larger bill.

How a rise in property tax flows through

The monthly amount rises by the increase divided by twelve, so a tax rise of 4,800 a year costs 400 a month. If the increase is discovered mid-year, the lender may collect a shortfall as well, so the first payment after a reassessment can be higher than the new ongoing level.

Mistakes with escrow budgeting

• Planning the budget on principal and interest alone and ignoring the reserve.
• Using last year's tax figure after a reassessment or after the property value has been revised.
• Overlooking that insurance premiums may rise at renewal, particularly after a claim.
• Treating a surplus in the account as your own money rather than a balance held for future bills.

Another source of confusion is the mismatch between billing year and calendar year. Tax may be billed for a fiscal year, so the due date can fall in a different month from the insurance renewal, and the account balance moves up and down through the year even though the monthly payment is steady.

A routine for keeping the reserve accurate

Collect the latest tax notice and insurance schedule each year and compare them with the lender's figures. If the lender's analysis differs, ask which assumption it used.

1. 1List both annual bills with their due dates.
2. 2Add them and divide by twelve to get your own estimate.
3. 3Compare with the lender's monthly reserve and ask about any cushion.
4. 4Recheck after any reassessment, renewal or change of cover.