You locked in a fixed rate, so the payment should never change. Then a letter arrives from your loan servicer with a new monthly amount, sometimes a lot higher than the old one, and a line about an "escrow shortage" you didn't know you had.
Nothing is wrong with your interest rate. On a fixed-rate loan the principal and interest portion really doesn't move. What changed is the part of your payment that goes into escrow, the account your servicer uses to pay your property taxes and homeowners insurance on your behalf.
Most homeowners with a mortgage have one, and most of them never read the annual statement closely until the number jumps (fair enough, it's a dull document).
What escrow is actually paying for
Each month your servicer collects your principal and interest plus roughly one-twelfth of what it expects your property tax and insurance bills to be for the year. Depending on the loan, mortgage insurance and flood insurance can be in there too. That money sits in the escrow account until the bills come due, and then the servicer pays them directly.
The upside is that you never face a giant tax bill all at once, and the lender knows the house is insured and the taxes are paid, which protects its collateral. The downside is that your payment is only as stable as your tax and insurance costs. When either goes up, your payment follows.
The annual escrow review
In the US, escrow accounts on most home loans are governed by the Real Estate Settlement Procedures Act, usually shortened to RESPA. Under those rules your servicer has to review the account once a year and send you an annual escrow statement showing what came in, what went out and what it projects for the coming year.
That review is where surprises come from. The servicer compares what it collected with what it actually paid. If your county raised your assessment, or your insurer raised your premium at renewal, the account will have paid out more than it took in.
Servicers are also allowed to hold a cushion, generally capped at one-sixth of the estimated yearly disbursements (about two months' worth). The cushion is there so a slightly bigger bill doesn't overdraw the account.
Shortage, deficiency and surplus
The statement will usually land on one of three outcomes, and they're handled differently.
A shortage means the account is projected to fall below the required balance over the coming year. The federal rules give the servicer a few options depending on the size of the gap. For larger shortages it generally has to let you spread the repayment over at least 12 months. For small ones it can ask for the money within 30 days or spread it out.
A deficiency is more serious: the account actually went negative because the servicer advanced money to pay a bill. Again you may be asked to repay it in a lump sum or over time, depending on the amount.
A surplus is the pleasant one. If the account holds $50 or more above what's needed and you're current on your payments, the servicer generally has to refund it within 30 days. Smaller surpluses can be credited against next year's payments.
Why your payment can jump twice
This is the part that catches people. When there's a shortage, your new payment includes two increases stacked together. One is the repayment of the shortage itself. The other is the higher ongoing monthly amount needed to cover next year's bigger tax or insurance bill.
So a $1,200 shortage doesn't just mean $100 a month extra for a year. If the underlying bill went up by $1,200, your regular escrow deposit also goes up by about $100. That's roughly $200 a month more for the first year, then dropping back to about $100 more once the shortage is repaid. Paying the shortage as a lump sum, if you can, removes the first piece and keeps the monthly increase smaller. (I'd only do that with money that isn't your emergency fund.)
What you can actually do about it
Start by reading the escrow statement line by line and comparing it with your actual tax bill and insurance declarations page. Mistakes happen, for example a servicer paying an old premium or missing a tax exemption you qualify for. If something looks wrong, RESPA gives you the right to send a written notice of error, and the servicer has to respond.
Then go after the bills themselves. Shopping your homeowners insurance at renewal, raising your deductible, or asking about discounts can bring the premium down. If your property assessment looks too high, you can check it and appeal, a process we walked through in our property tax guide. Make sure any homestead or senior exemption you're entitled to is actually on file.
Some homeowners ask about dropping escrow altogether. Conventional loans sometimes allow it once you have enough equity, often 20 percent or more, and occasionally for a fee. Government-backed loans such as FHA loans generally require escrow. If you do pay the bills yourself, you'll need the discipline to set the money aside every month, because the tax bill will arrive in one piece.
Before the next statement arrives
Many servicers run the escrow review around the same time each year, and property tax and insurance changes often show up in the following statement. It's worth a calendar reminder to look at your tax bill and insurance renewal as soon as they arrive, rather than finding out months later through a higher payment. A quick call to your servicer asking when your next escrow analysis is due takes five minutes and saves a lot of guessing.
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