What is Escrow?

Escrow is a financial arrangement where a homeowner pays portions of their real estate tax and homeowners insurance monthly to their lender, who then pays the bills when due.

A Longer Definition: Escrow

Escrow is a financial arrangement between a mortgage lender and a homeowner where:

1. The homeowner pays one month of their annual real estate tax bill and homeowners insurance premium in their monthly PITI to their lender.
2. The lender pays the homeowner’s taxing authority and insurance company as the bills come due.

Some mortgage types, like FHA mortgages and USDA mortgages, require buyers to set up an escrow account as part of the loan approval, with few exceptions.

Escrow is often required for conventional mortgages with low down payments. However, some lenders may also require escrow for larger down payments. If a buyer is given the option to waive escrow and chooses to do so, the lender may raise the interest rate or charge extra fees to offset their added risk.

Escrow accounts are established at closing. In some parts of the country, they are known as impound accounts.

A home buyer’s escrow contribution changes annually as their tax and insurance bills change. Starting escrow balances and estimated payments are based on prior year expenses, with a two-month cushion added in to ensure the account has sufficient funds to cover increases in costs.

Mortgage companies review escrow accounts annually for accuracy and over-collection. When a lender determines it over-withheld money from a home buyer, it is required to issue an escrow refund.

Conversely, buyers must make up a difference if there is a shortfall. Escrow true-ups can be handled via a one-time payment or by adjusting a mortgage payment upward to cover the escrow account deficiency.

Escrow: A Real World Example

First-Time Home Buyer Stories - Escrow

Consider a first-time home buyer who has just closed on a house. As part of their mortgage agreement, their lender sets up an escrow account to handle property taxes and homeowners insurance.

As part of their monthly mortgage payment, the homeowner pays a portion of their estimated annual taxes and insurance premiums which go into escrow. Then, when the tax and insurance bills come due, the lender uses the money in escrow to pay the homeowner’s bills.

The escrow arrangement is helpful for the homeowner because it splits up two large annual bills into 12 smaller payments and offers a convenient and worry-free way to pay them. For the lender, escrow is a guarantee that the home’s tax bill will stay current and its insurance policy will not lapse.

Common Questions About Escrow

Why did my mortgage payment go up?

When a homeowner’s mortgage payment goes up, and they do not have an adjustable-rate mortgage, the likely cause is escrow. When a homeowner’s escrow withholdings are too small to cover next year’s projected bills, the monthly PITI is raised to pay for the projected shortfall.

How much is escrow each month?

A homeowner’s escrow payment is one-twelfth of the estimated annual cost for property taxes and homeowner’s insurance on a property. For example, if your home’s taxes and insurance are $1,200 per year combined, your monthly escrow payment is $100.

What happens if there’s not enough money in my escrow account when my bills come due?

If your escrow account has a shortage when the bills come due, your lender will usually cover the shortfall on your behalf. Then, the lender will require you to make up the difference by either a lump sum payment or adjusting your future monthly escrow payments.

What happens if there’s too much money in my escrow account?

Mortgage lenders conduct annual reviews of escrow accounts. When an escrow account is over-funded, the lender refunds the excess escrow immediately.

Do escrow payments change over time?

Yes, escrow payments change over time. Each year, lenders conduct escrow analyses based on prior-year tax bills and insurance premiums. When a homeowner’s monthly escrow payment is too large or too small, the lender notifies the homeowner and makes adjustments in upcoming payments.

Is it possible to cancel an escrow account?

Sometimes, homeowners can cancel their escrow account if they have enough equity in their home, though this varies by mortgage lender and loan type. Canceling escrow means the homeowner is responsible for paying property taxes and insurance premiums directly.

What happens to my escrow account when I pay off my home?

When a home is owned free-and-clear, there is no mortgage company to manage an escrow account. Homeowners without a mortgage are responsible for paying property taxes and insurance premiums directly.

Are escrow accounts good?

Many homeowners like using an escrow account because it simplifies budgeting for property taxes and insurance premiums and protects against tax liens or lapses in insurance coverage. Lenders like escrow accounts for the same reasons.