For homeowners with a mortgage deciding whether to pay extra toward your escrow account or mortgage principal can be a confusing decision. Both can provide financial benefits so how do you know which one to prioritize? Here is a comprehensive look at the pros and cons of paying off escrow versus principal first to help you make the best choice for your situation.
What Is Escrow?
An escrow account is a third-party account used by most mortgage lenders to pay property taxes and homeowner’s insurance on the borrower’s behalf. A portion of your monthly mortgage payment goes into your escrow account, and your lender distributes funds from that account to pay your property taxes when they are due. The escrow payment amount is determined by your lender based on your home’s value and location.
Here are some key things to know about escrow accounts:
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Escrow funds are only used to pay for taxes and insurance. They are not used to pay down your mortgage principal or interest.
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Your lender is in charge of your escrow account and pays your insurance company and county when their bills are due.
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Escrow accounts provide convenience by handling tax and insurance payments for you.
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You don’t earn interest on money sitting in an escrow account.
What Is Mortgage Principal?
The principal balance is the amount you borrowed from the bank to buy the house in the first place. When you pay your mortgage, the principal is the amount that goes toward lowering the total amount you owe.
Paying down principal faster:
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Shortening the time you have to pay back the loan lowers the total amount of interest you pay over the loan’s life.
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Helps you build equity and ownership in the home at a faster rate.
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Allows you to eliminate PMI sooner if your down payment was under 20%.
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Gives you the option to refinance into a lower rate sooner.
Weighing the Pros and Cons
So when deciding whether to pay extra toward escrow or principal each month, consider these key factors:
Paying Extra to Escrow
Pros
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Prevents escrow shortages by keeping a buffer in your account
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Avoid headaches of tracking tax and insurance bills
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Potential refund of overage if escrow analysis shows excess funds
Cons
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Doesn’t reduce mortgage balance or interest payments
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Money doesn’t earn interest while sitting in escrow
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Don’t have access to the funds if you need cash
Paying Extra to Principal
Pros
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Pay off mortgage and build home equity faster
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Reduce total interest paid over loan term
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Eliminate PMI sooner by reaching 20% equity faster
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Option to refinance into lower rate sooner
Cons
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Need to budget for tax and insurance bills yourself
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Risk of falling behind if you miss a payment
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Don’t have access to extra funds if needed for other expenses
Which Should You Prioritize?
Generally, paying extra toward principal is the better long-term move for most homeowners. Reducing your principal faster builds equity and saves money on interest – providing greater financial benefit over time compared to putting extra in escrow.
However, paying to escrow can also be smart in certain situations:
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If your escrow account runs short often and you get hit with large escrow shortage payments
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If you don’t have the extra funds or discipline to save up for large annual tax and insurance bills yourself
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If you may need to cash-out equity in the next few years for expenses and want funds available
Ultimately, the ideal approach is to make consistent monthly contributions to both escrow and principal. This builds a comfortable tax and insurance buffer while still aggressively paying down your mortgage balance. If you have limited extra funds each month, even an extra $50-100 toward principal can make a difference long-term.
Tips for Managing Escrow and Principal Payments
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Review your escrow analysis to see if your account runs short or overfunded. Adjust your monthly escrow payment if needed.
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Set up automatic monthly transfers to principal to make extra payments easy and consistent.
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Try to pay at least an extra 1/12 of your annual principal to make one monthly mortgage payment extra per year.
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Consider temporarily paying to escrow if you have an adjustable rate mortgage and plan to refinance when rates improve. This keeps funds available.
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Monitor your escrow balance and request refunds of any overages to use toward principal instead.
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Shop home insurance rates annually and appeal tax assessments when possible to minimize escrow needs.
With the right strategy tailored to your mortgage and financial situation, putting extra funds toward principal and escrow can optimize your home loan payoff and savings. Evaluate your options annually and adjust your approach as needed to maintain the ideal balance.
What Is the Principal?
The principal of your mortgage is the actual loan amount. Much of what you pay for the first several years is interest. If you make a payment that’s over what you owe for the month, you can apply the extra to the principal amount. This lowers the amount you owe, which will lessen the amount of interest you are required to pay over the lifetime of your mortgage. Paying a little extra each month and directing it toward the principal can significantly shorten the length of your loan if you maintain the higher payments.
The escrow account is separate from your actual mortgage payment. An escrow account holds funds that have been set aside for additional expenses such as property taxes, homeowners’ insurance, or any fees that may need to be paid at a later date. While you can add money to your escrow account at any time, it won’t do anything toward lowering the actual amount of the principal. Your escrow funds may sit in the account for a long time without ever being touched.
Which Is More Important?
Both the principal and your escrow account are important. It’s a good idea to pay money into your escrow account each month, but if you want to pay down your mortgage, you will need to pay extra money on your principal. The more you pay on the principal, the faster your loan will be paid off. Choosing which one to make an additional payment on is up to you. Take the time to consider which one is more beneficial, and then make your payments accordingly.
Should I pay extra on my principal or escrow?
FAQ
Should you pay off escrow or principal?
There are benefits to paying extra on both accounts. Padding your escrow account is a good idea if you have an adjustable-rate mortgage that will allow your interest rate to go up. On the other hand, paying on your principal will pay off your loan much quicker and build equity in your home.
Is it better to remove escrow from mortgage?
You won’t save any money by having the escrow removed. You’re not paying interest on the escrow balance. It’s a placeholder to directly pay your taxes and insurance. So there is no financial point where it’s recommended to remove it – because it won’t make a difference either way. It’s a personal preference part.
Is it better to pay your escrow shortage in full or monthly?
If you pay a lump sum to an escrow shortage, the only real benefit is that you can keep the same monthly mortgage payment. I like round easy predictable numbers when it comes to quick month to month budget calculations and it was a silly low number to balance the account I figured why not.
What happens if I pay off my escrow balance?
Your loan company will probably either give you back the escrow balance or use it to pay off the loan balance due, depending on when the loan is paid off. If you are now responsible for paying the bill directly please contact the Collector’s office immediately so we may forward a copy of the tax bill to you.