Q. We have friends who are real estate investors and they have said that lenders force borrowers to establish escrow accounts for taxes and insurance just to get the free use of their money and it's all a racket. Our friends lean toward the cynical. Please give us your take on this subject.

A. The purpose of escrow or impound accounts is not to rifle money out of the pockets of borrowers; it is to guarantee that bills are paid on time. These accounts are designed to protect both the borrower and the lender. For homeowner's the most obvious advantage of impounds is that they automatically budget the borrower's tax and insurance responsibilities over the course of the year. Homeowners don't have to worry about coming up with several large, lump sum payments, each with different due dates, through out the year. At the same time the lender's interest is protected such that if there is ever a fire in the home, or if the basement floods causing damage, the lender and the homeowner can rest assured that the home is protected by a paid-up policy. While it is true that borrowers could establish accounts for these expenses themselves and thereby pocket the interest earned on these accounts during the course of the year, the interest earned on most accounts during 6 months is hardly worth the trouble for most homeowners.

It also frees homeowners from having to deal with unexpected increases in their taxes or insurance premiums because this responsibility falls to the lender to allow for possible increases in these payments. Even when there are not enough funds in a mortgage escrow account to meet increased tax or insurance payments, the lender typically covers the bill without charging interest to the borrower. It is not uncommon for lenders to pay taxes and insurance premium when they are due even though all the money for these bills has not yet been collected from the homeowner. It is estimated that in 2001 alone, lenders advanced more than $1 billion to homeowners who then avoided the penalties and risks of not paying their taxes and insurance on time.

Another resultant benefit of escrow accounts is that mortgages have lower rates and down payments because escrows protect the interests of investors in home mortgage loans. By making home mortgages more attractive and secure as investments, escrowing has led to a healthier mortgage market, resulting in loans with better terms and lower down payments.

Even state and local government operations are enhanced as it is a more efficient, less expensive means of tax collection. Rather than working with million of homeowners, municipalities need only collect from a few hundred lenders.

Lenders are enjoined from collecting more than 1/12 of the total amount of estimated taxes, insurance premiums and other charges reasonably anticipated to be paid. If the lender determines there will be a deficiency in the escrow accounts, the law permits the lender to require additional monthly deposits to avoid or eliminate the deficiency. Occasionally, however, mistakes do occur. I had a borrower last year for whom the lender had collected an amount in excess of what was required. After it had been called to their attention the money was refunded to the homeowner. Perhaps your friends' cynicism arose from just such an incident.

Incidentally, when you sell or refinance, the monies accumulated in these accounts are transferred to the new loan servicer (or credited to you in the event that there is no new loan servicer). An example of the latter would be the case with an outright sale but not a subsequent purchase.

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