Key takeaways
- Escrow accounts are used in two main ways for real estate: to hold earnest money when you make an offer on a home and to budget for property taxes, homeowners insurance and mortgage insurance premiums.
- Your lender conducts a yearly analysis to determine whether you have enough money in the account, and if you’re short, you’ll need to budget for higher monthly payments or make a one-time payment to address the shortage.
- Unless you make a down payment of 20 percent or more, you’ll likely need to set aside funds in an escrow account.
If you’re trying to figure out what a mortgage escrow account is, you’re not alone: A survey conducted by LERETA, a firm that specializes in tax and flood services for mortgage servicers, shows that only 52 percent of homeowners with an escrow account fully understand the account’s purpose.
The concept of putting money in escrow will play an important role in your life — from buying a home to making sure you’re current with all your financial obligations once you actually own it. Read on to learn how escrow accounts work, what role they will play in your life and whether you can avoid having one.
What is mortgage escrow?
“Escrow” refers to a financial instrument, generally an account, held by a neutral third party on behalf of two parties engaged in a transaction. With an escrow account, the funds are held or managed by the third party until the transaction is complete or a contract is fulfilled.
Though escrow accounts are commonly used in real estate, they also can be used for any other transactions that require an agreement between a buyer and seller, or require time to inspect what’s being purchased before payment is made.
How do escrow accounts work?
Think of an escrow account as a pile of money set aside for a designated purpose in the future: You know you’re going to need the money, so you’ll put that money away in advance to feel confident that you’ll have enough cash to cover the expense. As a homeowner with an escrow account, the account is typically designed to plan ahead for two main costs: your property taxes and your insurance.
Since insurance premiums and property taxes can change over time, your mortgage lender will conduct a yearly review, called an escrow analysis, to ensure that there are enough funds in your escrow account. Your lender will analyze the amount you’ll need to have in your account over the next year, breaking it down by month to determine the funds to pay in addition to the principal and interest for your mortgage. You’ll be informed of any changes to your account in a statement after the analysis.
Your lender may also require you to have an escrow cushion — a chunk of money in case your costs increase even further. The cushion amount can’t exceed two monthly escrow payments. In some states, a cushion may be limited to a smaller amount.
What happens if you have money left over?
If your cushion is too large at the time of your yearly escrow analysis, the lender or servicer is required to refund that money, or you can put it toward the loan principal on your mortgage.
Do you need an escrow account?
Not every lender requires an escrow account, but they’re common for a large number of homeowners. Here’s a rundown of common types of mortgages and when you’ll need to plan for an escrow account:
- FHA loans: If you’re using an FHA loan to purchase a home, you’ll definitely be required to have an escrow account to plan for mortgage insurance premiums and property taxes.
- Conventional loans with a low down payment: If you’re putting down less than 20 percent of the purchase price and taking out a conventional mortgage, your lender will require an escrow account that will include property taxes, homeowners insurance and your private mortgage insurance premiums.
- USDA loans: If you’re taking out a USDA loan larger than $15,000 (which probably applies to just about anyone), you’ll be required to have an escrow account.
- VA loans: The VA doesn’t have a specific requirement for an escrow account, but it does stipulate that it’s the lender’s responsibility to make sure all taxes and insurance premiums are paid on time. That means that most lenders will add in an escrow account.
You may be able to ask your lender to cancel your escrow account after you accumulate 20 percent equity and are paying off a conventional mortgage. However, that will put the responsibility on your shoulders. Translation: Don’t forget to set aside the money and set calendar reminders to get those bills paid on time.
Types of escrow accounts
Homebuyers escrow account
Your first encounter with an escrow account will likely be after the seller accepts your offer on a home. As part of your signing a purchase and sales agreement, you deposit earnest money to show the seller you’re serious about purchasing the property.
The amount deposited will vary, but typically it’s 1 percent to 2 percent of the purchase price. Make sure you have negotiated a contract that allows you to get your earnest money back easily for common issues. For example, an inspection that reveals major issues with the home, or the appraisal falls short of the agreed-upon sales price and the deal falls through. You might not get your earnest money back if you simply change your mind about buying the property.
Homeowners escrow account
Once you buy the home and begin making mortgage payments, a homeowners escrow account isn’t something you’ll think about or access on your own. Instead, the payments are rolled into your monthly payment and then stored in the escrow account. Rather than managing one bill for your principal and interest, another for property taxes, another for homeowners insurance and another for mortgage insurance, you’ll simply pay one sum with each bill.
The lender holds the funds for those other expenses in the account and then pays the bills automatically on your behalf. By holding your insurance and tax payments in escrow, your lender ensures that these bills are paid on time, avoiding penalties like late fees or potential liens against your property.
Who controls the escrow account?
During the home-buying process, buyers and sellers typically use a title company or bank to serve as the escrow agent that manages the earnest money deposit.
Once you become a homeowner, your mortgage lender is typically responsible for managing the escrow account. Your lender will take your mortgage payments and send a portion to the escrow account to cover insurance and taxes.
However, there’s no rule that states that the lender must manage the escrow account. The account can be managed by any trustworthy third party who is willing to handle the management of the funds. Under most mortgage servicers, individuals can’t control their own escrow account or directly remove funds from the account.
What are escrow fees?
When you’re buying a home, you’ll need to pay the escrow company to hold the funds and manage the transfer of the cash at closing. Those fees typically cost between 1 and 2 percent of the purchase price. However, they can look different depending on where you’re purchasing the home, and you may be able to negotiate to get the seller to split the cost of the fee.
Here’s a look at some typical escrow fee structures in different states:
- Arizona: Flat rate, ranging from $850 (properties worth $100,000 or less) to $1,750 (properties worth between $900,000 and $1,000,000)
- California: Approximately $2 per $1,000 of the property value, plus a flat fee of $250
- Kansas: Flat $550 fee, plus a $100 seller signing fee for loans up to $5 million
To properly budget for your escrow charges, ask your lender in advance for an estimate of how much the fee will be in your area.
Keep in mind:
There are typically no fees involved for your escrow account once you own the home. However, if you want to remove your escrow account after achieving 20 percent equity, be prepared to pay an escrow waiver fee, which is typically a percentage of your outstanding mortgage balance.
Pros and cons of escrow accounts
Pros
- No surprises: Since you’re already setting aside funds on a regular basis, you can avoid the shock of a big property tax bill in your mailbox. It’s forced savings to make sure you aren’t going to struggle to cover these essential bills when they’re due.
- No work on your end: Make one payment each month — that’s it. You don’t need to worry about heading to the post office to mail a bill, setting up online payment or calling anyone. That responsibility falls on your mortgage servicer’s shoulders.
Cons
- You won’t be paying attention to the costs: Having someone else manage these bills means you can easily forget to monitor increases. You’ll want to keep a close eye on these costs in case you want to compare more affordable homeowners insurance options or you think you should submit an appeal for a lower property tax bill.
- You can’t do anything else with the money: The money in escrow sits there until your servicer needs to pay the bills. If you’re a sophisticated investor who wants to chase higher returns, you may be frustrated by the inability to pursue growth opportunities.
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