I recently received notice that my mortgage payment will be going up next month due to higher property taxes and homeowners insurance. They are letting me choose between paying them a large lump sum today with a lower payment or a higher monthly payment. My fixed interest rate is low. Which should I pick: monthly or lump sum?

I still remember the first time I received one of these letters and how confused I was about what I was reading. Here’s what is happening:

The mortgage company wants to protect your and their mutual investment (your home). They don’t want you forgetting to pay your bills to jeopardize anything. As a result, the mortgage company will often structure loans such that they are the ones to pay off important expenses like property insurance and property taxes. You still foot the bill, but the mortgage company makes sure the bills are paid on time.

These home-related expenses are paid from what is called escrow. When you have escrow on your mortgage, some of your mortgage payment is paying off your loan (interest and principle) while the remainder is going towards the escrow account for home-related expenses.

The mortgage company is neither making nor losing money off of the escrow. They are just providing a bill pay service to protect their investment. Thus, if the actual costs of your property taxes or insurance increase, the previously agreed upon escrow portion of your payment will suddenly be insufficient to cover the new costs.

To ensure that they neither make nor lose money on the escrow, the mortgage company sends a projected escrow shortfall letter any time the bills they are paying go up.

These letters say that the escrow is insufficient to cover the upcoming costs and lays out the options just as this reader described: You can give the mortgage company a lump sum to make up the difference and keep your lower monthly rate or you can increase your monthly rate to cover the new costs.

Projected escrow shortfall letters are very common, and typically happen once per year.

Regardless of which home-related expense is increasing, our recommendation is the same: pay the increased monthly rate.

The escrow portion of your mortgage is not subjected to your interest rate, so regardless of whether you pay a lump sum today or gradually over the next several months, the total amount you will pay to the escrow will be the same.

If you were to pay the lump sum though, you would have less money in your pocket today without actually solving any problem. Next year, when all the costs stay the same, you’ll have another escrow shortfall and face this issue again.

In contrast, when you pay the increased monthly rate, more money stays in your pocket today. This means your money has more time to grow in the markets and also has more capability to solve financial shocks, should one arise. Additionally, you can more easily update your budget to the reality of your costs.

With no downsides and a few minor benefits, paying the increased rate is our default response.

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