“It would appear that we cannot use the funds for anything or than intended or they must be returned to the consumer.”
I agree with that statement. Reg X doesn’t say that the funds can be applied to the balance. It does say the servicer may retain the surplus in the escrow account pursuant to the terms of the federally related mortgage loan documents. Check your note/contract to determine if any other action is permitted.
Reg X 1024.17(f)(2) discusses surpluses.