Sunday, April 29, 2007

Do you like math?

Well, if you like math and you'd like to know how the heck lenders come up with the AGGREGATE ADJUSTMENT in the tax and insurance section of the settlement statement, grab a piece of paper and pull up a chair.

In my neck of the woods we have two annual payments for property taxes. In most areas we pay local & county taxes in the spring and school taxes in late summer. You can use your own property taxes figures or just follow along with mine. We'll also factor in hazard insurance.

$800 local & county tax next due at discount 3-30-08
$2000 school tax next due at discount 8-30-07
$450 hazard insurance next due 4-30-08
We are calculating escrow for a purchase transaction closing 4-30-07.
The first monthly payment for the mortgage will start 6-1-07.

Count the number of mortgage payments you will make between closing and the due date of each item. [It's okay to use your fingers. I do.] Ok, we have 10 for local & county tax, 3 for school tax, and 11 for hazard insurance.

The mortgage lender needs a full 12 monthly deposits into the escrow account to have sufficient funds on hand to pay the bill, so how many months do we need to collect at closing to make certain the lender has 12 months when the bill is due? We'll need to collect 2 for local & county tax, 9 for school tax, and 1 for hazard insurance. so, if we are preparing a HUD-1 those are the number of months we will collect in the escrow section.

To calculate the aggregate adjustment we've got to lay out the initial escrow account statement. We'll start by figuring out how much we collected on the HUD-1 and call that our starting deposit to escrow. Divide each tax and insurance figure by 12 then multiply it by the number of months we are collecting. If you're with me so far, we have 133.34 for local & county tax, 1500.03 for school tax, and 37.50 for hazard, giving us a starting deposit total of 1670.87.

Next we lay out proposed escrow activity for the next twelve months starting with the first mortgage payment. So, on your piece of paper write out a column with the first twelve months of mortgage payments starting with June.

The next column is deposits into the escrow account - each one is 1/12 of the taxes and insurance - or in our case, 270.84. [I'd really like you to write all of this out. Yes, I know computers do it for us now, but writing it out once in your life will really help you to understand how the escrow account works.]

The third column is expected payments out of escrow. We will have three payments, 2 for taxes and 1 for hazard insurance. Find the appropriate month and put the payment on that line.

The fourth and final column will have the running balance of the account. It will start one line up from our other columns with the starting deposit of 1670.87. These are your running totals:
1670.87 start
2212.48 July
483.32 August
754.16 September
1025.00 October
1295.84 November
1566.68 December
1837.52 January
2108.036 February
1579.20 March
1670.88 May

Take the lowest figure in this column and that's your aggregate adjustment. In this case it would be 483.32, which by putting a credit on the HUD-1 in that amount would cause the escrow account to zero out in August.

The lender has the right to cushion the escrow account by up to two months and most lenders do, so in reality, the aggregate would be 483.32 minus 541.66, or -58.34.

HA! Now with MW's revised figures we have a classic conundrum. Since the aggregate adjustment is really a credit on the HUD, showing up as a negative figure in a list of costs, theoretically we could stop here and our negative 58.34 would switch to a positive aggregate of 58.34. There is nothing wrong with a positive aggregate adjustment under the regulations. We have only bumped up the escrow to cover the two month cushion. BUT, in real life a positive aggregate adjustment just freaks out all lenders. There is a pervasive misconception that a positive aggregate adjustment is just plain wrong so to compensate for the misconception, you have to go back to the initial starting balances and jack them up until you get the aggregate into the negative. At this point, you could bump up any of the number of months as much as you want and recalculate the entire grid. The aggregate will adjust itself accordingly. Most lenders will be happy with any aggregate that is negative on the HUD.

The extra 541.66 left in the escrow mix protects lender and borrower from shortages when taxes and insurance go up, as they surely will over the life of the loan.

I hope this helps and I hope my math is okay. I was making it up as we went along using a really tiny calculator. It's not hard stuff. It's not rocket science, but if you see a mistake, PLEASE let me know. Thanks! [See comment. MW did put out an error which has now been fixed.]

Just one more thing. The interesting thing about escrow is that the formula will always balance out the actual starting deposit provided the dates and the underlying tax and insurance figures are correct. If you increase the number of months on the HUD, the aggregate will go up to compensate. It's a simple seesaw.

In the case of my positive aggregate that would freak out lenders, the actual cash going into the escrow would have been 1729.21. If I bumped up the HUD by adding another month to all the categories and ran the formula again, I would get a negative aggregate but the actual cash going into escrow would still be 1729.21.

This is why it's a misconception that the aggregate must always be negative. It will be negative if you have no cushion but if you elect to retain a cushion it is entirely possible and correct to have a positive aggregate adjustment.

That being said, just make it negative or all your lenders will freak. ;)


Diane Cipa, The Closing Specialists® said...

MW correctly pointed out that I have one too many monthly deposits in the June running total. Thank you MW!

I will make the change now.

Anonymous said...

if buyer would decide remove their insurance escrow from a transaction, would their cash required to close go up or down due to the aggregate adjustment??

Diane Cipa said...

It should go down a bit but not much. In a purchase, the amount going into escrow for insurance is only 2 to 4 mos less a relative adjustment.

The decision whether to escrow insurance is normally based on some other reasoning than cash to close. The requirement to pay a full year in advance stands in either case.

Thanks for reading and Happy Halloween. ;)

Anna said...

I am sorry but I don't understand how you got to 483.32 in august.

Diane Cipa said...

Hi, Anna.

Here are the assumptions:

$800 local & county tax next due at discount 3-30-08
$2000 school tax next due at discount 8-30-07
$450 hazard insurance next due 4-30-08
We are calculating escrow for a purchase transaction closing 4-30-07.
The first monthly payment for the mortgage will start 6-1-07.

So when you come to August, you need to add the monthly deposit and deduct the payment for school tax.