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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.
Escrow is a financial arrangement between a mortgage lender and a homeowner where:
Some mortgage types, such as FHA mortgages and USDA mortgages, require home buyers to establish an escrow account as part of their approval with limited exemptions.
Other types, such as conventional mortgages, require escrow only when home buyers use low-downpayment mortgages to purchase their home.
Escrow accounts are established at closing. In some parts of the country, they’re 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’s required to issue an escrow refund.
Conversely, buyers must make up a difference if there’s 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.
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 won’t lapse.
When a homeowner’s mortgage payment goes up, and they don’t have an adjustable-rate mortgage, the likely culprit 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.
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.
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.
Mortgage lenders conduct annual reviews of escrow accounts. When an escrow account is over-populated, the lender refunds the excess escrow immediately.
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 small, the lender notifies the homeowner and make adjustments in upcoming payments.
Sometimes, homeowners can cancel their escrow account if they have enough equity in their home, though this varies by mortgage company and loan type. Canceling escrow means the homeowner is responsible for paying property taxes and insurance premiums directly.
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.
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.
This article, "What is Escrow?" draws on the author's professional mortgage experiences and references information found at these authoritative websites:
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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.
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