What is mortgage escrow?

When you’re using a mortgage to buy a home, there’s a good chance your lender will require something called an escrow account. Here’s what escrow means, and what you need to know about this important part of the mortgage process.

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 remoquire an agreement between a buyer and seller, or require time to inspect what’s being purchased before payment is made.

When do you need an escrow account?

Mortgage escrow accounts, also called impound accounts in some parts of the country, are often required by lenders. Typically, you’ll need an escrow account if your down payment is less than 20 percent, or if you’re financing your home purchase with an FHA loan or USDA loan, but not with a VA loan.

Types of escrow accounts

In real estate, there are two main uses for escrow accounts:

• To hold earnest money when you purchase a home
• To pay homeowners insurance, mortgage insurance and property taxes

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. (In competitive markets, some buyers have been putting up much more for this good faith deposit to make their offers more attractive.)

You’ll get your deposit back if an inspection 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 the home is yours, you may encounter another type of escrow account. For homeowners, a mortgage escrow account is a special holding account for your homeowners insurance premiums, your mortgage insurance payments and property tax payments.

Typically, you don’t directly pay these bills from this account, or even deposit money for these bills into it. Instead, your mortgage lender will collect these payments on a monthly basis as part of your mortgage payment, hold them in the account, then pay 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.

The amount of money in the account can change over time, because insurance premiums and property tax assessments fluctuate. If there’s ever a shortfall, your lender will still cover the payment (and then eventually increase your monthly mortgage payment to make up that difference). The lender will send you an escrow analysis annually that identifies whether your account has a shortfall or is overly funded, and how your monthly payment will be adjusted as a result.

Establishing this sort of escrow account often requires two to three months’ worth of insurance premiums and property tax payments upfront at the time of closing.

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?

It’s common for the escrow agent involved in the sale of a home to take a fee of 1 percent of the purchase price, though this percentage can vary widely depending on location.

In addition, some mortgage lenders might allow you to waive the escrow requirement and pay your insurance and tax bills directly — for a fee.

How escrow accounts work

What is escrow analysis?

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. From there, your lender will project if you’ll have a shortage or an overage. (In reality, rising property taxes and insurance mean that escrow accounts rarely have an overage.) You’ll be informed of any changes to your account in a statement after the analysis.

What is an escrow cushion?

An escrow cushion is an extra amount above your mortgage payments that your lender or servicer is allowed to collect and hold. The cushion amount can’t exceed two monthly escrow payments. In some states, a cushion may be limited to a smaller amount.

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.

Pros and cons of escrow accounts

The biggest advantage to an escrow account is that it takes the responsibility out of your hands. You can’t forget to save money to pay your property taxes because you’ve been required to save money every month and send it to your mortgage servicer. You can’t lose the bill and forget to pay your homeowners insurance because your servicer is doing it on your behalf.

The biggest disadvantage to an escrow account: the loss of control over the funds. While it’s great to put money away, the fact is you’re paying bills before you need to. Maybe you have other good uses for those funds — like putting them in a savings account or investing them. So you’re losing out on potential gains or interest, a chance to make your money work for you, or even just have handy if an emergency arises.

Another disadvantage with escrow accounts is that, since you’re not handling bills directly, you may not be aware of the individual costs. You may not notice how much you’re paying for homeowners insurance, so you’re less likely to shop around and get the best deal. You may not pay as much attention to how much you’re paying in property taxes so you may not remember to vote against a property tax increase.

Escrow fraud and scams

Keeping informed about your escrow account is essential, and not just from a budgeting perspective. Due to the often large amount of money held in escrow, these accounts have become targets for scammers.

The types of scams vary, but one common scheme is duplicating your lender’s or servicer’s website or email communications in an attempt to get your login credentials or have you wire funds to a fraudster. Some scams even set up official-sounding phone numbers as another way to build trust and get you to reveal your login information.

Always carefully review any communications relating to your escrow account and alert your lender or servicer if you suspect fraudulent activity.