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.
What Does Escrow Mean?
Generally, escrow is a type of account. It is held and managed by an escrow agent — a neutral third party who not only receives money, but can disperse it. The escrow account is held for two primary parties until a transaction is finalized or a contract’s requirements are met.
Escrow accounts are most often used in real estate. But, escrow can also be used for purchases that require a consensus between a seller and buyer. Money is also put into escrow when something being purchased needs an inspection before any payments are made.
Lenders can use escrow accounts to complete your mortgage, property tax and insurance payments. The account is funded every month as part of your monthly payment.
[Read: Best Mortgage Lenders]
How an Escrow Account Works When You’re Buying a Home
An escrow account is where the homebuyer’s initial deposit — sometimes called earnest money or a good-faith deposit — is held by an escrow agent 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.
There are no ongoing fees associated with managing an escrow account, says Brian Koss, regional director of Movement Mortgage, a mortgage lender in Fort Mill, South Carolina. However, there is an escrow fee that will be included in the closing costs when you buy a home.
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 Brewster, 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.
Escrow accounts can last for the life of the loan or until the borrowers opt out, if they have that option, says Koss.
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. Your annual property tax amount from the accessor and the annual homeowners insurance premium from the insurance company are broken down into a monthly cost basis, and that monthly amount is added to your monthly principal and interest mortgage payment, says Carey. In this case, an escrow account is basically a savings account, he says. Every time you make a mortgage payment, some of that money goes into your escrow account. If you look at your mortgage statement, you’ll see the amount that is being contributed.
Homeowners can think of escrow as a forced budgeting for important parts of your mortgage payment, says Koss. “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. That’s why your monthly mortgage payment is sometimes referred to as a PITI payment, which stands for principal, interest, taxes and insurance.
Then, once the tax bill or insurance premium is due, the lender pays from the escrow account on the homeowner’s behalf. “It’s all handled behind the scenes, and you don’t have to worry about rushing to pay your taxes or insurance in time,” says Carey.
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Are Funds in Escrow Refundable?
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.
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.
[Read: Best Mortgage Refinance Lenders.]
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.
[Read: Best Adjustable-Rate Mortgage Lenders.]
Pros and Cons of Escrow Accounts
Pros:
Ensures on-time payments.
Escrow helps ensure homeowners aren’t late on their bills by making automatic payments towards insurance and tax bills. For homeowners using an escrow account, it can alleviate the stress of coming up with a large payment to cover those bills.
Lower mortgage costs. By making use of an escrow account, you could possibly receive a discount on your interest rates and closing costs.
You’re protected. Over time, the prices of insurance and taxes could fluctuate. So, if your escrow account is short on funds due to a bill increasing, your escrow agent may temporarily cover the difference. But, expect your monthly mortgage payment to eventually go up in order to make up for that coverage.
You know what to expect. Your monthly mortgage payment includes the amount required for escrow by your agent, so you’ll almost always know what to expect. And your lender will send you a written notice if the escrow involved in your monthly mortgage payment needs to increase. Annually, you’ll also receive an escrow statement by your lender that displays what you’ve paid.
Cons:
Upfront payments. When you open an escrow account you may need to deposit funds that are equal to two or three months’ worth of property taxes and insurance. Your mortgage closing costs could also increase because of this.
Scam target. Scammers may find the large amount of funds loaded in escrow accounts as an appealing target. Mortgage escrow fraud commonly manifests itself as a fake website that looks almost identical to your lender’s. Scammers could also call you and persuade you to wire them money, or get in contact with you through email using addresses that are similar to your lender’s.
Unable to gain interest: Don’t expect to earn any interest from most escrow accounts. The large amount of money you have in your account could earn huge interest in a savings account, for example. But escrow accounts don’t earn interest, so you’re technically missing out on a big bang for your buck.
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What Is Escrow? originally appeared on usnews.com
Update 12/20/23: This story was published at an earlier date and has been updated with new information.
