- Key insight: At least 12 states have passed laws requiring banks to pay interest on escrow accounts in a complex legal battle over federal preemption of state laws.
- What's at stake: The case deepens a federal circuit court split that has major implications for banks and the states' ability to enforce consumer protection laws
- Expert quote: "There are billions of dollars at stake in these decisions." — Joseph DeFazio, partner at Troutman Pepper Locke
A multi-billion dollar battle over whether national banks should be required to pay interest on mortgage escrow accounts could return a second time to the Supreme Court.
New York borrowers asked the Supreme Court late last month to weigh in
While it is rare for the Supreme Court to take a case twice, legal experts think it is likely in this situation because the legal landscape for national banks is now divided following several conflicting appellate rulings.
"There are billions of dollars at stake in these decisions," said Joseph DeFazio, a partner at Troutman Pepper Locke. "From a practical standpoint, paying 2% interest on large escrow balances is a real expense across billions of escrow funds that translates into material dollars each year that the banks have to cover themselves."
In most cases, the amounts held in escrow are relatively small, as banks collect borrowers' payments for property taxes and insurance before they are due. But in some instances, larger sums of money are at stake.
As an extreme case, following the California fires that destroyed Altadena and the Pacific Palisades in January 2025, mortgage servicers are holding in escrow six-digit and seven-digit insurance checks until payments are due to the contractors who are rebuilding lost homes.
Borrowers in California who received significant sums from insurance payouts for the fires currently are paid interest on their escrow balances. Last year, the U.S. Court of Appeals for the Ninth Circuit reaffirmed that paying interest on escrow accounts does not "significantly interfere" with banks' powers under the National Bank Act.
But last month a panel of the U.S. Court of Appeals for the Second Circuit sided with national banks in a decision creating a direct conflict with rulings from both the First and Ninth Circuits. Both courts had previously upheld interest-on-escrow laws, in Rhode Island and California, respectively.
In 2024, the Supreme Court vacated and remanded the Second Circuit case,
"These issues, as esoteric as they seem, end up being a big deal, and these types of court decisions define the parameters between federal and state law," said Patrick Haggerty, partner and managing director at Klaros Advisors, and a former senior attorney at the Office of the Comptroller of the Currency.
The ongoing litigation unfolds alongside a parallel effort by the OCC
"The OCC taking the formal step of issuing a preemption determination seems like it sets up something where, how does anybody know what's up and what's down without [somebody resolving it," Haggerty said.
Among the many nuances of the case is the Dodd-Frank Act, in which Congress concluded that the aggressive preemption decisions taken by the OCC had contributed to the subprime mortgage meltdown by creating a regulatory vacuum. To address this, Dodd-Frank
specifically eliminated federal preemption for the operating subsidiaries of national banks, which aggressively used federal preemption to shield non-bank subsidiaries from state consumer protection laws and licensing requirements.
Dodd-Frank also established the controlling test for determining when federal law preempts state law. Known as the Barnett standard, based on a 1996 landmark Supreme Court case, it dictates that a state law is preempted, or overridden by federal law, if it "prevents or significantly interferes" with a national bank's exercise of its federally granted powers.
"The Ninth Circuit decision pointed to Dodd-Frank to say states should be allowed to regulate this aspect of national bank powers," said Haggerty.
The OCC, in its final rule, said that it is "codifying longstanding powers of national banks and federal savings associations to establish or maintain real estate lending escrow accounts and to exercise flexibility in making business judgments as to the terms and conditions of such accounts, including whether and to what extent to offer any compensation paid to customers or to assess any related fees."
Brandon Milhorn, president and CEO of the Conference of State Bank Supervisors, said the OCC's final rule was a "watered-down, unlawful preemption standard" that "encroaches on state sovereignty and creates needless uncertainty for the banking industry and consumers."
"Federal preemption applies only when a state law prevents or significantly interferes with the exercise of national bank powers — not simply because the OCC considers a law inconvenient, inefficient, or unusual," Milhorn said.
The OCC and national banks are defending federal preemption.
The American Bankers Association argued in
The OCC also said in its final rule that banks have the discretion to pay interest on escrow accounts.
"The terms and conditions of escrow accounts, including whether and to what extent banks pay interest or other compensation, are ultimately a business judgment made by each bank in accordance with safe and sound banking principles," the
States are likely to argue that the OCC's rules are arbitrary and capricious, in violation of the Administrative Procedure Act. Moreover, following the Supreme Court's 2024 ruling in
The Supreme Court may act soon.
"I think it's highly likely that the Supreme Court will take up the case again," said Peter Idziak, a principal at Polunsky Beitel Green, a law firm focused on residential mortgage lending. "Within a few weeks, we may know for certain whether the court intends to take up the issue and provide a definitive ruling."
Until the litigation is resolved, many banks, including BofA, are paying interest on escrow accounts in states that require it. Escrow accounts are embedded in the mortgage lending process to ensure the timely payment of taxes and insurance.
At its core, the question facing the courts is whether forcing national banks to pay a fixed rate of interest meaningfully impairs their ability to manage and price mortgage products in general, DeFazio said.
"The money's got to come from somewhere," said DeFazio, referring to banks paying at least 2% interest. "If state escrow interest mandates are broadly allowed, you have to expect the structure of mortgage pricing to shift so that some of that cost is built into rates and fees. These costs are always passed on to consumers."
Federal preemption comes with unintended consequences as well. State-chartered banks and nonbank mortgage servicers generally must comply with state law. If national banks are preempted, it creates uneven competitive playing field in the mortgage industry.
Going forward, if the Supreme Court accepts the
"You have to consider the situation of the wildfire victims whose homes burned down and insurance paid out hundreds of thousands for rebuilding, if not more, for some of those homes," DeFazio said. "Those funds are in an escrow or restricted account sitting for a long time. At 2%, you're talking $6,000 a year in interest across many, many, many loans. That's material dollars."
The states that have passed laws requiring the payment of interest on escrow accounts include California, Connecticut, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Utah, Vermont and Wisconsin.
