New Construction Escrows Explained

This article is relevant to home loans where property taxes are part of the monthly mortgage payment. A basic understanding of escrow accounts and how lenders perform an escrow analysis is required to fully comprehend how new construction escrows accounts work.

Escrow accounts can be very confusing when purchasing a newly built home. The monthly mortgage payments for new construction home loans can increase dramatically after closing depending on how the escrow account is created.

Escrows accounts are regulated

It’s important to know that escrow accounts are regulated by the federal government. There is a formula that determines the amount of money that is allowed to be impounded. The formula is exactly the same for all lenders.

What the escrow formula doesn’t determine is the value to use for the property taxes.

For example, the formula may determine that eight months of property taxes are required to be collected at closing. However, the amount can be based on either the unimproved value or improved value.

Your payment amount is your choice

Most lenders allow the homebuyer to choose whether the escrow account is based on a the fully improved value of the home or the unimproved value of the home. (Although, most lenders won’t notify you of this option).

Unimproved tax value result in higher payments later

We do not recommend that homeowners choose an artificially, and temporarily, lower monthly payment based off the property’s unimproved value.

The reason is because a year or two later, the monthly mortgage payments will increase substantially once property taxes are assessed on the improved property value.

Use the improved value to avoid significant payment increases

It is our recommendation that initial escrow accounts are created using the estimated improved value of the home. Opting for a higher (and more accurate) monthly payment, where property taxes are based on the sales price, will minimize the payment adjustment in future years.

Downfall to using the improved value

There is a temporary downfall to using the improved value as a basis for property taxes when establishing an escrow account for new construction. The amount due at closing will be higher because of how tax prorations work.

Escrow accounts can only be collected using one tax value. By choosing to use the taxes of the estimated improved value, the escrow account will be properly funded. The downfall occurs with the tax prorations.

At closing the seller will issue a credit to the buyer for their portions of the year’s property taxes. However, if the current year’s property taxes are based off the unimproved value, the amount of credit will be very small compared to the new escrow account balance that uses the improved value.

This will result in an escrow overage and a surplus of money required at closing. The excess amount will be refunded the following year after the mortgage servicer does the escrow analysis.

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Example of new construction escrows

Let’s assume a newly constructed home is purchased in June of 2020 for $400,000. Let’s also assume the land value is $50,000 and the property tax rate is 2.4%.

In Texas, the tax assessor conducts their value assessments during the first few months of a year. This typically occurs around March.

The annual property taxes for the unimproved land is $1,200 per year, which is $100 per month. ($50,000 x 2.4%).

Conversely, the improved value of $400,000 would have a $9,600 annual tax bill, which is $800 per month. ($400,000 x 2.4%).

Payments based on unimproved land value

If the lender established the new escrow account using the unimproved property taxes (i.e. the $100 per month), the monthly mortgage payment for the remainder of the year will be artificially low.

The taxes due at year-end will be $1,200 since the valuation in March was based on the unimproved land. The escrow account will pay the $1,200 and will be “in balance” since the payments for taxes are based off that unimproved assessment of $100 per month.

The next March (in 2021) the county will assess the value comparable to the sales price of $400,000. However, the payments will remain the same, artificially low amount on the unimproved land from the prior year. Remember, escrow accounts are regulated and lenders and won’t increase the payment since the escrow account is in balance.

An escrow shortage is pending

At the end of the year (2021) – a year and a half after the purchase’s closing – the property tax bill of $9,600 will come due. However, only $1,200 has been collected for taxes. This creates an $8,400 deficit in the escrow account.

The Mortgage Servicer will ultimately pay for that deficit to prevent the county from placing a tax lien on the home. The Servicer will then send a letter notifying the homeowner that the $8,400 is due and payable.

Two things will happen:

  1. The mortgage servicer will increase the monthly payment by $700 per month to make the total tax collected to be $800 per month,
  2. The servicer will also require the escrow shortage to be paid. This can be done in the form of a lump sum payment at that time, OR by increasing the monthly payment another $700 to recoup the $8,400 shortage over a twelve month period. This means the payment increased by $1,400 for that year.

Lessor Worst Case

A lesser worst case example would be if the home was partially completed during the county’s value-assessment in March. The unimproved value could be closer to the improved value of the home.

For example, if the foundation and framing was completed at the time of county’s assessment, the valuation may be $100,000 or $125,000 instead of the initial $50,000 land value.

Everything from the aforementioned example would pertain to this scenario as well. The only difference would be that the escrow tax payments would be off a higher value and reduce the future deficit.

Recommendation: base taxes on the improved value

A new construction home loan with an escrow account can be subject to having a significant increase in monthly payment after the first year depending on how the escrow account was setup at closing.

We recommend that your lender base your initial escrow account on the estimated property taxes for the improved value (i.e. the sales price) and not the unimproved value (i.e. the lot value). This will most likely result in an escrow surplus when an escrow analysis is conducted.