Whether you’re buying a home for the first time or refinancing an existing mortgage, you will likely encounter the term “escrow account” throughout the process. For many homeowners, escrow remains one of the least understood aspects of homeownership.
If you’re unsure about how escrow works, this guide will help clear things up. What exactly is an escrow account, and why is it used?
What is an Escrow Account?
An escrow account is a third-party financial account used to hold funds during a real estate transaction between a borrower and a lender. In most home purchases, it is set up by the lender after closing to collect and manage funds for property-related expenses such as homeowners’ insurance, property taxes, and HOA fees.
Once the loan is finalized, the lender collects a portion of these costs as part of the monthly mortgage payment. These funds are then deposited into the escrow account. When bills such as insurance premiums or property tax payments become due, the mortgage servicer pays them on the homeowner’s behalf using the funds in the account.
This system helps ensure that essential property expenses are paid on time. It is also commonly referred to as an “impound account.” In many cases, escrow balances may change over time because property taxes and insurance premiums can increase, which can affect the monthly payment amount.
How Does an Escrow Account Work?
Here’s what your escrow account actually does each month, so you can budget without fear:
- Your lender calculates yearly expenses:
Once you’ve established your mortgage, your lender or mortgage servicer will estimate what they expect to pay out of your escrow account within the next 12 months based on your current property tax and insurance rates (plus any required PMI).
- Monthly funds are automatically deposited:
This annual amount will be divided by 12 and added to your principal and interest payment. Combined, the two will form your monthly mortgage payment (which is known as PITI for principal, interest, taxes, and insurance).
- Funds accumulate in the escrow account:
Each month, as you send in your PITI payment, a portion will be set aside in the escrow account.
- Bills are paid out of the escrow account:
As your property tax bill or homeowner’s insurance policy comes up for renewal, the lender or mortgage servicer will use the funds that have been accumulating in the escrow account to make these payments for you. You don’t need to do anything!
- An escrow analysis is completed:
Every year, your lender or mortgage servicer will conduct an escrow analysis to determine if the initial annual calculation was accurate. If there were overpayments for the year, you might receive a check. If there were underpayments (say, if local property taxes increased during the year), the monthly payment to cover your taxes will increase in the next year.
What Expenses Will an Escrow Account Fund?
Generally, two main categories of expenses will be paid from your mortgage escrow account:
Property Taxes:
Property taxes are set by local governments and vary by state, county, and even city. They are typically paid once or twice a year, and failure to pay them can result in a tax lien on the property and, in severe cases, foreclosure.
Because property taxes are one of the largest recurring expenses of homeownership, lenders often require borrowers to pay them through an escrow account.
Homeowner’s Insurance:
The property you’ve mortgaged is the collateral for your loan. Since your lender has a vested interest in the property, they’ll want it insured. Paying for homeowners’ insurance through escrow ensures the coverage won’t expire. If the cost of your homeowner’s insurance goes up when it renews, your escrow account payment will be adjusted during the next annual review.
Additional Expenses That May Be Included:
- In escrow, depending on your loan and property, several other expenses may be paid from an escrow account, such as:
- PMI (Private Mortgage Insurance)- this applies when you make less than a 20% down payment
- Flood Insurance- if you live in a zone prone to flooding, you’ll need to have flood insurance that’s managed through escrow
- Homeowner’s Association (HOA) dues- under some circumstances, these are included in an escrow payment
Will you need an Escrow Account?
Whether you will need an escrow account is determined by a combination of your loan type, your lender’s policy, and the size of your down payment.
Most conventional mortgages require an escrow account when the down payment is less than 20% of the purchase price. This is because a lower down payment results in a higher loan-to-value (LTV) ratio, which represents greater risk for the lender.
FHA loans and VA loans typically require escrow accounts regardless of the down payment amount.
Some lenders might offer to let you forgo an escrow account if you pay 20% or more of the home value down, although there can be an additional charge from some lenders for doing so.
Benefits of Having an Escrow Account
The Advantages Of Having An Escrow Account. While it doesn’t appear to add any money to your bank account, there are some benefits for homeowners having an escrow account – especially those who may be purchasing their first property:
- Budgeting is easier – the amount that includes principal, interest, taxes, and insurance payments is one simple, set amount per month
- No big, lump sum – property taxes and home insurance aren’t due all at once at tax or policy renewal time, but spread over 12 equal months
- Peace of mind – since your loan lender will automatically remit tax and insurance payments on your behalf, there’s a reduced risk of late fees or lapsed coverage
- Protect against foreclosure – regular payments mean local governments don’t issue a tax lien against your home
- Automatic adjustments – as your tax and insurance amounts change, your escrow is adjusted to match
Conclusion
Whether or not you plan to utilize a buyer’s real estate agent or not, your own funds can and will probably be set aside into an Escrow account each time you apply for or close on a real estate transaction.
For first-time home buyers who don’t really fully understand the full workings of the real estate and real estate financing procedures, an escrow account can be a valuable asset as well. It essentially functions as a 3rd party that oversees the transfer of ownership of property as well as payments for said property. The fact remains, your monthly mortgage payments won’t always consist of the payments toward principal and interest. For the loan to remain in good standing and to avoid any future problems, the lending institution will require that a portion of your monthly payment go into an escrow account to pay property taxes and homeowner’s insurance on your behalf annually.
At Reliance Financial, we’ll help walk you through all the steps, from making sense of the escrow process all the way down to securing you the very best loan possible. Rely on our team of experts and find the perfect mortgage for you. Located in the heart of CA, serving homeowners in CA, TX, FL, CO, MI, VA, and WA.
FAQs
What is the purpose of an escrow account in a mortgage?
In an escrow account, your lender puts aside money for things like your home’s property taxes and homeowners’ insurance, making it easy for you to avoid a big payment every year.
How is my monthly escrow payment calculated?
The lender takes your projected annual home insurance and property taxes, then divides them by 12, and the monthly amount is automatically added to your principal and interest payment.
Can I opt out of having an escrow account?
You can sometimes skip the escrow account on a conventional mortgage if you have a minimum of 20% equity, but with FHA and VA loan requirements, you might not have this option, regardless of how much you put down.
What happens if there is a shortage in my escrow account?
When your lender reviews your escrow account on an annual basis and finds out that money fell short of the escrow balance due to a tax or insurance cost increase, it will notify you so you will be able to either lump some cash or distribute it as part of a higher payment for the next 12 months.
Will I receive a refund if my escrow account has a surplus?
If the annual review shows you have overpaid your taxes and insurance through your escrow account, your lender has to give it back to you by check or by reducing your mortgage payments.
Does my escrow account change if property taxes or insurance rates increase?
The bank must review your escrow on an annual basis, so if the insurance cost or home tax rates increase, your escrow monthly contribution must increase, too.
