Mortgage escrow account pros and cons

A mortgage escrow account is an integral part of the financial picture for many homeowners. These accounts are typically used in two ways: to hold an earnest money deposit a buyer puts on a home after signing a contract with the seller (it’s released at the closing), and to pay a homeowner’s property taxes, mortgage insurance and homeowners insurance premiums.

When it comes to the latter, some homebuyers are required by their mortgage lender to have an escrow account; others may opt into one through their mortgage servicer. Here’s how mortgage escrow accounts work, and if you do have a choice, the pros and cons to consider.

How do mortgage escrow accounts work?

Once you become a homeowner, a mortgage escrow account is an account used to hold and ensure that some of the major, ongoing expenses associated with your home are paid on time. Typically these expenses include:

• Mortgage insurance payments
• Homeowners insurance premiums
• Property taxes

Instead of paying insurance and taxes separately, from a personal account, the money to cover these bills — plus a little extra, known as a “cushion” — is included in your total monthly mortgage payment. The mortgage lender or servicer holds these funds in an escrow account and makes the payments on the homeowner’s behalf as they are due. Payments might be made monthly, quarterly or bi-annually.

The key difference between an escrow account and any other financial account you might have: You don’t manage an escrow account yourself. Escrow is facilitated by a third party — in this case, your lender or servicer.

Should you use an escrow account?

Depending on the type of loan and its specifics, you might not have the option to forgo an escrow account. If you’re obtaining a conventional mortgage — that is, one from a private bank or lender — an escrow account is often required with a down payment of less than the standard 20 percent, as is mortgage insurance. You often don’t have a choice if you’re getting a federally backed loan, either. FHA loans and USDA loans require escrow accounts, though VA loans do not.

Let’s assume you do have a choice. There are viable reasons to have an escrow account: It can be an easy, hassle-free way to make payments for your mortgage, homeowners and mortgage insurance and property taxes, and the cushion can help cover potential shortfalls. You don’t need to be diligent about setting aside the funds, including extra for any unforeseen increases in premiums or taxes, and then making sure you meet the due dates for payments. Of course, there are negatives as well — it increases your monthly mortgage payment, and you might prefer to handle your own finances yourself, without a third party involved.

Pros of a mortgage escrow account

It’s automatic

Having your mortgage lender or servicer hold your property tax and homeowners insurance payments in escrow ensures that those bills are paid on time, automatically. You don’t have to keep track of it, or even think about it, and you avoid penalties such as late fees or potential liens against your home.

You’re covered when there are shortfalls

Homeowners insurance premiums and property tax assessments can fluctuate over time. For example, if your escrow account happens to be short due to your property tax bill increasing, your servicer will typically cover the difference temporarily. To make up for it, they’ll eventually increase your monthly mortgage payment.

No surprises

The exact amount needed for escrow is added to your monthly mortgage payment for you, so you’ll know what to expect the majority of the time. If the escrow component of your monthly mortgage payment needs to increase, you’ll get a notice from your lender or servicer in writing. Plus, your lender or servicer is required to send you an annual escrow statement that shows the amounts you’ve paid (and the drawdowns) along with any overages or shortages.

“Escrow accounts make life a lot easier for the majority of homeowners that want to add predictability to their monthly expenses, rather than getting whacked twice a year with big insurance and property tax bills,” says Greg McBride, CFA, Bankrate’s chief financial analyst.

Potentially lower mortgage costs

Depending on your mortgage lender, you may be able to get a discount on your interest rate or closing costs just by having an escrow account.

Cons of a mortgage escrow account

It’s automatic

While it’s convenient to not have to think about making various payments on time, this pro can actually be a con for organized homeowners who prefer to have full control over their payments. Many mortgage lenders allow homeowners to make property tax payments directly to the county assessor and homeowners insurance payments to their insurer.

You might miss out on investment opportunities

In particular, the money that might end up as an overage in an escrow account could be used for short-term investments. Earning interest on such investments may make more financial sense for you, instead of allowing a bank or lender to reap the gains.

Digital tools and attractive CD rates can help you invest your money outside of escrow and earn a better return for the long term, notes Henry Yoshida, founder and CEO of Rocket Dollar, a platform based in Austin, Texas, that enables users to invest funds from tax-advantaged retirement accounts.

“With interest rates where they are, there is limited opportunity cost from forgoing interest earnings on money that is instead being escrowed by the loan servicer throughout the year,” McBride says.

A large upfront deposit

Often, setting up an escrow account requires a homebuyer to deposit an amount equal to two to three months’ worth of property taxes and insurance premiums. These are sometimes called “prepaids,” and they can significantly add to your mortgage closing costs.

Because you’ll be paying for insurance and taxes with your regular mortgage payment, you’ll have a higher payment each month. Of course, you have to pay for insurance and taxes anyway, so they aren’t an additional cost. But having them in your monthly payment could leave less room in your budget month-to-month, and prepaids can exacerbate that.

Can be a target for scammers

Large sums parked in an escrow account make it an attractive target for fraudsters. Common mortgage escrow fraud schemes include cyber-thieves setting up fake websites that look similar to the servicer you’re working with, or spoof email addresses to try to get your personal information. Some sophisticated scammers even set up fake phone lines in an attempt to build trust. Under these false pretenses, fraudsters might try to persuade you to wire them money.

Possibility of incorrect estimates

The amount that needs to be tucked away in your escrow account hinges on your insurance premiums and property taxes, which can vary year-to-year. Generally, the previous year’s bills are used to figure out how much you’ll need, but incorrect estimates can happen if, for example, the assessed value of your home has increased — or you appeal and get a reduction in your property taxes.

FAQs

• Is an escrow account required if I'm buying a house without a mortgage?

  No. Mortgage escrow accounts are typically only required with certain types of loans — if you’re not financing your home purchase with a mortgage loan, it’s not a requirement. You can pay your insurance and property taxes on your own if you choose, as you would any other types of bills, or you can set up an escrow account at your bank if you’d like the convenience of them doing it for you.
  

• Who manages the money in an escrow account?

  An escrow account for a home purchase is managed by a third party, such as a mortgage servicing company, escrow agent or escrow company. Its purpose is to pay for taxes and insurance — the funds are included in your total monthly mortgage payment, and the servicer or agent makes the payments automatically on your behalf. Many people find this convenient, but some would rather manage their finances themselves.
  

• Can I take money out of my escrow account?

  No, you cannot take money out of your escrow account. The money held in a mortgage escrow account is held by the lender or loan servicing company on your behalf, to serve a specific purpose, and it is not typically accessible to the homeowner.
  

Bottom line

With a mortgage escrow account, your mortgage lender or servicer is allowed to collect the amount of your homeowners insurance, mortgage insurance and property tax payments, sometimes plus a cushion, month in and month out. It’s a very common financial tool and helps to ensure your obligations as a homeowner are met without much effort on your part (aside from making your mortgage payment). However, if escrow isn’t required, you might want to explore alternative uses for those funds.