Most people never encounter the concept of escrow until they buy a home. Escrow accounts are set up by third parties as a safe place to hold money. They are used for two main purposes when it comes to real estate: during a home purchase and afterward as an easy way for homeowners to save for property tax and insurance costs.
Here’s what you need to know about escrow accounts, how they help facilitate a home purchase and how they help you manage your home expenses after the sale.
How an Escrow Account Works When You’re Buying a Home
An escrow account is where the buyer’s initial deposit (sometimes called earnest money or a good-faith deposit) is held until the sale moves forward. Once the buyer and seller reach an agreement, the money held “in escrow” will be released and applied toward the buyer’s down payment. If the sale falls through because of the sellers, the money will be returned to the buyers. If it’s the buyers who back out, they may have to forfeit the deposit. Details about what happens to earnest money should the sale not go through will be in the purchase contract.
The other part of the homebuying process with an escrow account is when the sellers set money aside as an “escrow holdback.”
“This is usually in connection with some kind of repair that the buyer is asking the seller as part of the negotiated sale,” says David Carey, vice president, residential lending manager at Tompkins Mahopac Bank in Lagrangeville, New York. Typically, the seller will have to put aside 1.5 times the amount of what the repair will cost, and then once it is completed, the escrow will be released back.
An escrow holdback could also be used for other reasons, such as if the buyer allows the seller to remain in the home past the closing date, or if it’s a new construction that still needs some updates after the buyer moves in, or if a home is bought during winter and required repairs cannot be made until spring. The funds offer the buyer protection in case anything is damaged and to ensure that work is completed.
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How an Escrow Account Works for Paying Property Taxes and Insurance
Once you’ve completed your home purchase, your mortgage lender may open an escrow account for you so that you can save up enough money to pay the property taxes and homeowners insurance for the home you are purchasing. In this case, an escrow account is basically a savings account, says Carey.
Homeowners can think of escrow as a forced budgeting for important parts of your mortgage payment, says Brian Koss, executive vice president of Mortgage Network, an independent mortgage lender in Winchester, Massachusetts. “By accruing your tax and insurance costs monthly, your lender is just acting as your budget manager and ensuring there will always be enough in your escrow account to pay for these items on time,” he says. This is so you — and your lender — aren’t at risk of losing the house due to unpaid taxes, or if there’s a fire and the home is not insured.
Here’s how the tax and insurance amount is calculated: At the time of loan origination, the lender gets the annual property tax amount from the assessor and the annual homeowners insurance premium from the insurance company. “These two amounts are broken down into a monthly cost basis, and that monthly amount is added to your monthly principal and interest mortgage payment,” says Carey.
That’s why your monthly mortgage payment is sometimes referred to as a PITI payment, which stands for principal, interest, taxes and insurance. Note that the lender may also tack on some cushion for your monthly tax and insurance payments at the start of the escrow account, adds Carey.
Then, once the tax bill or insurance premium is due, the lender pays from the escrow account on the homeowner’s behalf. The benefit is that because it’s automatically part of the mortgage payment, the homeowner doesn’t have to worry about coming up with a lump sum, says Carey. “It’s all handled behind the scenes, and you don’t have to worry about rushing to pay your taxes or insurance in time.”
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Your Escrow Questions, Answered
Even though escrow is something that is handled behind the scenes by your lender while you make mortgage payments, you might still have questions.
How do you put money into escrow? Every time you make a mortgage payment, some of that money goes into your escrow account — it’s as simple as that. If you look at your mortgage statement, you’ll see the amount that is being contributed.
Are funds in escrow refundable? If for some reason there is a significant balance left in your escrow account at the time of escrow analysis and reconciliation (which is conducted annually by the lender), you are entitled to a refund of that amount, minus any required cushion of funds to be retained, says Carey. “Many lenders offer the ability to carry over the escrow surplus and reduce your monthly mortgage payment during the next calendar year, or they can refund these funds to you at your request,” he says.
It could also happen that there is an escrow shortage, like if you have a large increase in your property taxes. “You run into this occasionally when there’s new construction and the new assessment hasn’t been completed prior to closing,” says Carey. “Then the house gets assessed and the taxes increase significantly.” If this happens, the lender will either increase your monthly payment to spread out your additional escrow obligation, or give you the option to make a lump-sum payment so you can keep your monthly payment the same.
What fees are associated with escrow accounts? There are no ongoing fees associated with managing an escrow account, says Koss. However, there is an escrow fee that will be included in the closing costs when you buy a home. You may also be charged a fee if you choose to opt out of escrow.
How long do you pay escrow? Escrow accounts can last for the life of the loan or until the borrowers opt out, if they have that option, says Koss.
Who manages the escrow account? The lender who holds your mortgage manages the escrow account, says Carey. Thus, the lender is responsible for paying your tax and insurance on time, as well as performing an escrow analysis each year to make sure your account is funded enough to continue making tax and insurance payments.
Can you opt out of having an escrow account? Some lenders have an escrow requirement in place to mitigate their risk, says Carey. For example, escrows may be mandatory for certain types of loan programs, for high loan-to-value loans, for first-time homebuyers, or in cases where the homeowner has a history of missing tax and insurance payments.
Once you reach a certain equity in your home, you may have the opportunity to opt out, but there is usually an upfront fee involved, Koss says. Plus, continuing to pay for taxes and insurance will become your responsibility.
Some people might want to opt out and take control, like if they had a poor experience with a mortgage servicer in the past. Many homeowners find it easier to just keep paying into the escrow account.
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