Lack of Escrow Accounts Hurts Subprime Borrowers

As financial regulators and Congress probe more deeply into delinquencies and foreclosures in the subprime home loan market, one contributing factor is receiving increased attention: the lack of mandatory escrow accounts.

According to some industry estimates, most subprime mortgages closed during the housing boom years carried no escrows for property taxes and hazard insurance. That is in stark contrast to the prime mortgage market for consumers with good credit, where mandatory escrow accounts are routine.

"It's an upside-down world," said Michael D. Calhoun, president and chief operating officer of the Center for Responsible Lending, a consumer advocacy group. "The people you'd think need an escrow the most aren't required to have them, and the people who need them the least are forced to use them."

Escrow accounts are set up by lenders to guarantee the timely payment of property-tax bills and insurance premiums. On top of principal and interest charges for the mortgage every month, the lender also collects money to be paid when tax bills and insurance premiums come due during the year. In that sense, escrow accounts are a safety net for homeowners and lenders alike.

When a borrower fails to pay real estate taxes, local governments can file liens against the property and force its sale to obtain the unpaid amounts. The lender then faces financial loss if the sale proceeds are not enough to pay off the mortgage. Escrows for insurance also are designed to protect the homeowner against loss in the event of a fire or other damage, and to cover the lender's security interest in the property.

Subprime lenders dispense with mandatory escrows to keep monthly payments low. That's an important lure because the interest rates they charge often are 3 percentage points or more above prime market rates, and many clients already have high debt and modest incomes. But the lack of escrow accounts also places heavy responsibilities on the borrowers to accumulate enough money during the course of the year to pay tax and insurance bills, and to know when those bills come due.

Roy Rangel, a broker with Statewide Mortgage and Lending in San Antonio, calls the lack of escrow accounts "a killer" for financially strapped, unsophisticated borrowers "who don't really understand that the payment they're making every month isn't everything that they owe, and they've got to come up with $3,000 or $4,000 more to pay taxes and insurance."

When those borrowers' regular principal and interest payments jump by 40 percent or 50 percent from their artificially low introductory levels, "then they're in really big trouble, they are drowning," Rangel said.

Rangel recently refinanced a loan for a young couple on the verge of foreclosure. They had bought their first house in 2004 with a "2/28" subprime adjustable rate loan at 7 percent, meaning it had a low rate for the first two years. With no escrow account, the monthly payment was just $703. After the first two years, their payment jumped to $857.

"But the real trouble," Rangel wrote in an e-mail, "was the fact that they did not have an escrow account." Their insurance carrier abruptly withdrew from the business of insuring property hazards, leaving them with no coverage. Their lender then "force placed" substitute insurance costing $1,700 a year, nearly double the premium they had before. Also, because they hadn't paid their property taxes, the lender paid them, leaving the couple owing an additional $5,000.

To recoup the $5,000, Rangel said, "the lender increased their monthly payments to $1,646" -- far beyond what the couple could afford.

Rangel was able to refinance the loan -- including the $5,000 extra -- by putting the couple into a fixed rate, FHA-insured mortgage at 6.25 percent, with a mandatory escrow account and a monthly payment of $1,130.

Federal financial regulators have begun focusing on the subprime industry's frequent omission of escrow accounts. In proposed guidelines issued March 8, regulators from the Federal Reserve, Treasury and other agencies said lenders should disclose and explain upfront to credit-impaired borrowers that without an escrow, the burden is completely upon them to pay all property taxes and insurance premiums in a timely manner, and that such payments "can be substantial."

Consumer advocates, however, say Congress ought to consider forcing subprime lenders to use escrows.

"I think the failure to escrow on subprime mortgages is an abusive practice," Calhoun said. "We think escrowing should be mandatory."

Bottom line for borrowers: If you have impaired credit or irregular income, recognize the greater risks when your monthly payment doesn't cover everything you owe.

Kenneth R. Harney's e-mail address is KenHarney@earthlink.net.