What is Escrow on Mortgage?
Learn How It Works
What is Escrow on a Mortgage?
Escrow is an important part of the home buying process that helps ensure property taxes and homeowner's insurance are paid on time.
When you get a mortgage, your lender will set up an escrow account to hold funds for these recurring costs.
So what exactly is escrow? Here's an overview of how it works and what it covers when you buy a house.
What is an Escrow Account?
An escrow account is a special account that your mortgage lender sets up to pay property taxes, homeowner's insurance premiums, mortgage insurance and other recurring costs on your behalf.
When you close on your home loan, the lender calculates how much they estimate you'll need to pay for taxes and insurance in the first year. This amount gets divided by 12 and added to your monthly mortgage payment.
For example, if your property taxes are estimated at $3,600 for the year and your homeowner's insurance is $1,200 annually, the total $4,800 gets divided by 12. That's $400 extra per month to your escrow account.
This way, when your tax and insurance bills come due, the money is already set aside in your escrow account to pay them. Your lender makes the payments for you by withdrawing the funds from the account.
Who Manages the Escrow Account?
Your mortgage lender manages your escrow account over the life of the loan. They keep records of all the payments going in and out of the account and provide you with an annual escrow analysis statement.
This statement shows the escrow account activity for the past year and projects what your new monthly escrow payment will be in the upcoming year. Your lender must analyze the account annually to ensure there are enough funds to cover upcoming bills.
If the account has a surplus, you may get a refund check from the lender. If there is a shortage, they will increase your monthly escrow payment to build up the balance.
Benefits of an Escrow Account
Having an escrow account through your lender provides several key benefits:
Convenience - The lender makes the tax and insurance payments for you so you don't have to worry about keeping track of when they are due.
Avoid penalties - The lender ensures bills are paid on time, avoiding any penalties or lapses in insurance coverage.
Budgeting - Including taxes and insurance in your monthly mortgage payment makes it easier to budget. The amount is fixed each month instead of having to save up for large annual or bi-annual bills.
Potentially lower interest rate - Some lenders offer an interest rate discount on loans with an escrow account set up.
What Does the Escrow Account Cover?
A mortgage escrow account typically covers the following recurring costs:
Property taxes - Local property taxes are often paid in one or two large installments each year. The monthly escrow funds make sure the money is available when needed.
Homeowner's insurance - Premiums are usually paid on an annual or semi-annual basis. The escrow account collects funds each month to pay the premium when it comes due.
Mortgage insurance - Required if you put less than 20% down, mortgage insurance premiums can either be paid monthly or annually using escrow funds.
Flood insurance - If required for your area, premiums for flood insurance policies are paid from the escrow account.
HOA fees - Some lenders will include HOA fees in the escrow account for convenience, although this is not required.
What Doesn't Escrow Cover?
The escrow account is limited to the specific recurring expenses outlined above. Other regular homeownership costs are still your responsibility to pay separately:
Utility bills - electricity, gas, water, etc.
Home maintenance - repairs, improvements, lawn care, etc.
Mortgage payment - your loan principal and interest are not paid from escrow
Home warranty - Optional protection plans are not covered
Escrow Accounts for Home Buying
During the home buying process, escrow takes on an additional role related to the transaction itself.
In real estate closings, an escrow or settlement agent will manage the exchange of funds during the transaction. They receive the purchase money from the buyer and hold it until the closing date.
At closing, they transfer the money to the seller after ensuring both parties meet all requirements outlined in the purchase agreement. This helps protect both the buyer and seller.
The escrow account your lender sets up for taxes and insurance is separate from the real estate transaction escrow. Make sure to understand each escrow account and its purpose.
Drawbacks of Escrow Accounts
While escrow accounts offer many benefits, there are a few potential drawbacks to consider as well:
Higher upfront costs - At closing, you need to fund the escrow account which increases your total cash needed to close.
No interest earned - The funds in escrow accounts do not earn interest like they would in your regular bank account.
Lack of control - You rely on the lender to make timely payments and do not have direct access to the funds.
More work if you pay taxes yourself - Getting your property tax bills sent directly to you takes an extra step if you prefer to pay them without escrow.
Bottom Line: Is Escrow Worth It?
For most homebuyers, the convenience and peace of mind provided by escrow outweigh the minor drawbacks.
By having your lender manage the payment of taxes and insurance, you avoid any risk of late fees, cancellations or tax liens due to forgetting when bills are due.
Escrow simplifies the homeownership process by incorporating certain costs into your monthly mortgage payment. Just make sure to review your escrow analysis statements and ask your lender any questions you have about the account.
Maintaining open communication ensures escrow works smoothly for you.
Frequently Asked Questions
Q What is a mortgage escrow?
A mortgage escrow is a financial arrangement in which a third party holds and manages funds on behalf of a borrower to cover certain expenses related to the mortgage, such as property taxes and homeowners insurance.
Q How does a mortgage escrow work?
When you have a mortgage escrow, a portion of your monthly mortgage payment is set aside in an escrow account. The escrow account is used to pay property taxes, homeowners insurance, and sometimes other expenses when they come due.
Q What expenses are typically covered by a mortgage escrow?
Mortgage escrows typically cover property taxes and homeowners insurance. In some cases, they may also cover mortgage insurance or other property-related costs.
Q How is the amount for the mortgage escrow calculated?
The amount for the mortgage escrow is calculated based on the estimated annual costs of property taxes and homeowners insurance. Your lender will divide the annual amount by 12 and add it to your monthly mortgage payment.