Years ago, when I first heard the term, “escrow,” I had no clue what it meant. In fact, many of the terms used in real-estate transactions are not often used outside of the industry. So, for me, “real estate” truly has been a third language to be mastered.
According to Realty Times, to escrow means to put something, such as a deed or money, in the custody of a neutral third party until certain conditions are met.
In practical terms, it means to let someone else hold your money to ensure that a lump sum of money is readily available on or before each due date.
You may have heard the term, PITI. Let me explain. When you take out a loan to buy and hold a property, for the most part, your monthly loan payment is made up of two components: principal and interest (PI). There are two additional major annual expenses associated with holding a property. One is tax and the other is insurance (TI). Combining all four components, you have principal, interest, tax, and insurance or PITI.
In theory, it makes no sense to escrow your money with a third party, especially long term, does it? Why would you let someone else have the ability to earn interest on your money? You could escrow your own funds in an interest-bearing account and pay when due. In fact, it is a good idea to get used to the idea of escrowing your own funds so that when you no longer have mortgage payments, you remain disciplined to set aside the annual amounts for tax and insurance, both of which remain intact whether or not you have the principal and interest payments. So, with our investment properties, I used to be dead set against escrowing funds for tax and insurance.
Then came 2008. That year, our house was struck by lightning. Between the fire and water from the fire engines to put out the fire, the house needed to be demolished and rebuilt. You may recall that this was also the year when both capital and real-estate markets crashed.
Because I was in the middle of a 5-year goal to accumulate properties by December 2009 – to be prepared to completely replace pension and social security income – nothing was going to stop me. Such stubbornness in the middle of a market crash, however, turned out to be a near-fatal, financial mistake. Before long, annual tax and insurance payments for all properties came due as well, seemingly all at once. That was like adding fuel to the fire. Of course, hindsight is 20/20.
In economics, we use the term “ceteris paribus,” which means, “with all other conditions remaining the same.” For me, ceteris paribus would mean no large-scale market crash, no house fire, and no consequent financial distress.
Ceteris paribus, I still believe that the theory of not escrowing your funds with a third party makes the best sense.
In practice, in my case, however, it would have been much less stressful to have had the annual tax and insurance premiums escrowed and included as part of the monthly mortgage payments.
So, whether to escrow or not to escrow is a decision only you can make based on your own specific situation and circumstances.
Happy investing!
