Real estate tax and escrow/reserves explained…

Homebuyers and refinancing homeowners are often confused at closing about their mortgage lender escrow reserve payment and lender requirements.

Typically if a homebuyer’s down payment amount is less than 20%, or a refinancing homeowner’s equity is less than 20%, a lender will require a escrow reserve account controlled by the lender for the purpose of paying homeowner’s insurance premiums and real estate taxes.

The lender has good reason to collect an escrow reserve payment because it’s in the lender’s interest to make sure homeowner’s insurance premiums are paid in since the lender is also a named insured under the policy. Equally important to the lender, real estate taxes must be paid in order to avoid a tax lien, which would become a priority lien over the lender’s mortgage lien.

For the purposes of this discussion of escrow reserve payments, we’ll focus on real estate taxes.

A lender will require the homebuyer to pay a deposit at the time of closing to establish the escrow reserve account such that the lender has enough money for payment of future real estate tax bills.

Beginning with the homebuyer’s first monthly principal and interest mortgage payment, the lender will include 1/12th of the annual real estate taxes.

The escrow reserve payment, or deposit into the escrow reserve account, is calculated based on the number of months before the next tax bill is due against the number of months the lender will have collected through the mortgage payments from the date of closing.

For example, if you are closing in January then your first mortgage payment will be due on March 1. Yes, that’s correct – March 1 – because the lender will collect prepaid interest from the date of closing through January 31. That makes your first payment due on March 1 because mortgage interest is paid in arrears.

Your March 1 payment will cover the interest that will have accrued in the month of February.

So if you close in the month of January and the next semi-annual (6 mos.) tax bill is due on July 15, the lender will require a real estate tax escrow reserve payment, or deposit, equal to 3 months worth of taxes.

This is because from March 1 through July 1 you will have contributed 5 months worth of real estate taxes through your mortgage payments and with 3 months already paid into the escrow reserve account at the time of closing, the lender will have a total of 8 months worth of real estate taxes in order to pay the 6-month tax bill.

But wait! Why does the lender have 8 months worth of taxes when they only need 6 months worth of taxes to pay the bill? Well, by law, the lender is allowed a 2-month cushion to help cover for any sudden real property tax re-assessments or other supplemental tax bills.

The charts below should help homebuyers or refinancing homeowners in calculating how many months will be required by their lender as a deposit for real estate tax escrow reserve for properties in DC, Maryland and Virginia.

DC Tax Periods
1st Half 10/1-3/31 (Due 3/15 -Paid in Arrears)
2nd Half 4/1-9/30 (Due 9/15 – Paid in Arrears)

MD Tax Periods
1st Half 7/1-12/31 (Due 9/30 – Paid in Advance)
2nd Half 1/1-6/30 (Due 12/15 -Paid in Advance)

Arlington, VA Tax Periods
1st Half 1/1-6/30 (Due 6/5 -Paid in Arrears)
2nd Half 7/1-12/31 (Due 10/5 – Paid in Arrears)