Escrow: What is it and how does it work?

As a home buyer, your mortgage lender and title company will require you to use an escrow account as part of the real estate purchasing process. Escrow’s meaning may not be apparent to you at first, but it’s not hard to grasp.

On the one hand, “escrow” effectively refers to a third-party bank account where your earnest money will be stored and safekept as the sale of the property finalizes. An escrow account, which is managed by a neutral third party such as a title company or real estate attorney, essentially holds onto these funds, keeping them safe until certain contractual obligations are met.

Also, a second form of an escrow account is used by mortgage lenders as part of a real estate purchase. It allows buyers to set aside funds that are needed to cover any property taxes or homeowners insurance that may pop up down the road.

That said, let’s dive deeper into escrow’s meaning and how the process works. Knowing its mechanics and benefits can help you do business with more confidence and ease.

What is an escrow account?

Escrow is used in real estate transactions for two purposes:

• It allows a buyer to put down a good faith deposit that will only be paid in keeping with the conditions of the real estate transaction.
• It holds a select amount of funds in safekeeping, setting them aside to cover any property taxes or homeowners insurance that a property owner may owe on an annual basis.

Given the different purposes to which escrow can be put, be advised that two types of escrow accounts exist. One is used during the home buying process, while the other is used throughout the life of your loan.

Escrow accounts for home buying

As part of a real estate transaction, your home purchase agreement will include clauses concerning earnest money. It’s essentially a good faith deposit paid into a third-party account to demonstrate to the seller that you’re serious about making the home purchase.

 Should the contract to buy the property fall through due to actions that leave the buyer at fault, the seller generally is able to keep the earnest money in exchange for their troubles. In the event that the home purchase is successfully completed though, the buyer gets to apply the earnest money toward making their down payment.

Whatever the case, during the process of preparing to buy the home, a third party will set up an escrow account to safely hold the earnest money deposit. Funds essentially remain in the escrow account until buyers and sellers complete all contractual obligations (like making requested fixes or repairs on a property) until the transaction closes.

That said, it’s not uncommon for a select amount of funds to also be reserved and held in another type of escrow account following the completion of a real estate sale transaction. The practice is known as an escrow holdback and may occur for several reasons, depending on the terms of the contract between the home buyer and seller.

By way of illustration, as part of the purchase, you may have agreed that the seller can reside in the home for an extra month while they secure a new home of their own. Alternately, certain forms of maintenance or upkeep may be needed on the home that the seller is responsible for (for example, fixing roof leaks or landscaping a lawn) before they can receive payment.

Should you be building a new home from scratch, note that it’s also standard practice for money to remain in escrow until you’ve signed off on all the work to be performed. Once the contract’s terms and conditions have been met in full, any funds held in escrow will be released to the right party.

As a general rule, home buyers will be required to complete the sale of the property and sign off on any necessary paperwork to release funds that are being held in escrow.

Escrow accounts for taxes and insurance

If you’ve taken out a home mortgage to purchase a property, your lender may also set up an escrow account to hold funds to pay for your taxes and homeowners insurance as part of the transaction. You may also hear these escrow accounts referred to as impound accounts, depending on the state in which you reside.

In practice, this means that as part of every month’s mortgage payment, your loan servicer sets aside a portion of the funds paid in the escrow account until your tax and insurance payments are due. That way, you aren’t caught flatfooted by these bills when they later arise. Mortgage escrow helps you more conveniently organize any payments that you may incur related to owning your home, including mortgage (principal and interest), home insurance, and property taxes.

Each year, your home mortgage servicer will calculate escrow payments for the next year ahead, based on the amount of your current year’s bills. Be advised, though, that the amount of money that’s required to be put in escrow here is a moving target because both property tax bills and homeowners insurance premiums can change significantly from year to year. To ensure that enough cash in held in escrow in the event of any adjustments that may occur at a following date, most lenders require that you maintain a minimum of 2 months’ worth of extra payments in the account.

Also be advised that as part of servicing the loan, your lender will analyze your escrow account on an annual basis to make sure they’re not collecting too much or too little. Should the analysis of your escrow account determine that too much money has been collected for taxes and insurance, they’ll give you what’s called an escrow refund.

Who manages an escrow account?

Escrow accounts can be managed by all manner of neutral third parties such as escrow companies, real estate attorneys, title companies, escrow agents and mortgage servicers. Where you are in the real estate purchase and transaction process will determine who manages the account.

Escrow companies and escrow agents

As you go through the home buying process, including contracting and inspections, escrow may be managed by a mortgage servicing company or agent, who may sometimes be the same as the title company that you’re using.

In effect, the escrow company that you’ve chosen not only manages the buyer’s deposit, it may also be responsible for holding the real estate deed and other documents related to the sale of the property.

Note that because an escrow company is working for both the buyer and the seller under the terms of any given real estate transaction, the fee for their services is usually split evenly between the two parties. This allows for potential savings as you go about making a home purchase.

Mortgage servicers

A mortgage servicer oversees and manages the day-to-day operations and mechanics of payment and upkeep from the time of closing on the property until you pay off your loan. Mortgage servicers, which may change from time to time as home loan products are resold, are responsible for collecting your mortgage payment, maintaining the records of payments, and managing your escrow account.

If your loan is still with the financial institution that you initially secured it from, you’ll hear your mortgage servicing company referred to as your originating lender. But this won’t be the case if the lender has sold the servicing rights to the mortgage, as above. In any event, it’s helpful to research and find out before signing up for a mortgage whether your lender typically services their own loans. That’s because the loan may otherwise freely trade hands, and not all mortgage servicers provide the same level of support, financial assistance (if needed), or customer service.

Having a mortgage servicer to manage an escrow account means that you don’t have to worry about your tax or insurance bills as they pop up. Rather, your loan servicer will compute how much you owe, collect payment as needed over an extended period of time, and make sure that they know who to pay and when. By collecting and recording payments and forwarding tax and insurance payments, the practice saves you from unexpectedly receiving what could potentially be a large bill.

Note that the only exception is if you change insurance providers or policies. In these circumstances, you’ll need to provide the new policy information to your servicer to make sure that their records are up to date.

The benefits of an escrow account

As noted, escrow accounts provide a cost-effective and convenient way to automate payments and enjoy greater peace of mind by ensuring that you’re sticking to your household budget. A leading perk of having a Rocket Mortgage® escrow account is knowing that you’re being taken care of by the most awarded mortgage company ever, based on J.D. Power’s consumer surveys.

For home buyers

An escrow account helps safeguard and protect your deposit as you go through the process of purchasing a home.

For instance, imagine that you’ve executed a purchase agreement with the seller, but the sale fails to complete due to certain contingency clauses or issues found during inspection.

Had you paid the deposit directly to the seller, it may be hard to obtain a prompt and full refund. But because a neutral third party is holding the funds, you can instead be confident that they’ll be returned in timely fashion, per the terms of your agreement.

For homeowners

Having an escrow account in place with your mortgage lender helps minimize financial surprises and helps you avoid having to scramble to come up with significant sums to cover an unexpected tax or insurance bill. In effect, because you’re making more manageable payments in advance and doing so all year long, you can budget for these costs more effectively and rest easier knowing that you’re covered.

Also helpful is not having to keep tabs on due dates for tax bills and insurance premiums. At the time these expenses come due, your mortgage servicer effectively handles them and makes certain that the charges are paid on time, every time. Doing so helps minimize effort and confusion and ensures that you won’t face additional expenses due to late payments.

As a backup, your mortgage loan servicer will even cover any bills that arise for you if your escrow account is short on funds. However, you’ll still be financially responsible for making up any shortages that arise later.

For lenders

Lenders also have strong incentive to make certain that your insurance and property taxes are being paid in full and timely fashion:

• Should your tax bills go unpaid, the tax authority could put a lien on your home – which could ultimately end up costing your mortgage lender money if the tax authority chooses to foreclose on the property.
• In the event that your homeowners insurance coverage lapses, significant damage to or loss of the real estate holding could result in a substantial decrease in its value.

As you can see, having an escrow account on the loan provides greater peace of mind for all parties, and allows your mortgage lender to ensure that all bills are being paid in full when due.

The drawbacks of escrow accounts for homeowners

While you won’t encounter any significant disadvantages associated with having a mortgage escrow account, you’ll still want to take a number of different factors into consideration here:

Higher monthly mortgage payments

Funds for an escrow account are paid via your monthly mortgage payment. As a result, monthly bills and charges are higher than without these added amounts attached. But funding an escrow account also means not having to scramble to pay significant amounts of taxes or insurance when due. As a general rule of thumb, account for an escrow balance adds about 1% – 2% to the total purchase price of a home in escrow fees.

Lower escrow estimates than actually required

How much that you’ll need to set aside for escrow depends on your property taxes and homeowners insurance costs, which (as noted earlier) can change from year to year. Your mortgage loan servicer will determine the total amount of funds that are needed based on the previous year’s bills.

Keep in mind, though, that upon first moving into your new home, the property will be reassessed by the government for tax purposes. Doing so can cause your property taxes to increase (and sometimes do so substantially), especially if the home value has risen since it was last purchased. In other words, a mortgage lender’s calculations are just an estimate, and when your servicer estimates the escrow, they may not be able to predict an increase in your property taxes.

Because of this, and at subsequent times over the years as you hold onto the property and tax assessments increase, your escrow balance may also come up short. In the event that this happens at such periodic intervals, you’ll have to pay the shortage by making an increase in your monthly escrow payment.

In any event, you may wish to set aside a cushion of 15% – 20% of your previous year’s escrow costs each year to cover any potential increases. Doing so can help you avoid being short on funds should an increase occur.

Changes to your monthly payment

Because the amount needed for escrow is reassessed each year, the exact dollar amount of your monthly payment may change with each passing year.

In effect, on an annual basis, your servicer will calculate a new escrow estimate for the year ahead. If as time passes you find that you’re coming up short on the actual amount due, so too will your mortgage payment increase to cover the difference.

What escrow accounts don’t cover

Escrow accounts help you set aside funds for future expenses, but don’t cover every charge related to home ownership, including but not limited to:

• Utilities (electricity, gas, water, etc.)
• Maintenance and upkeep
• Homeowners association (HOA) fees
• Supplemental tax bills, which may arise from changes in property ownership or new construction, are also generally not managed through your escrow account. That said, should supplemental tax bills become severely delinquent (and therefore threaten a lender’s interest in the property), the servicer may pay them as a one-time disbursement from escrow, which the borrower must eventually pay back.

Do you need an escrow account?

You need an escrow account in a few situations.

For instance, certain home loan borrowers must have an escrow account in place, such as those with government-backed loans that have been issued with the help of the Department of Veterans Affairs (VA) and Federal Housing Administration (FHA).

For VA loans, for example, you’ll need 10% down and a strong credit profile to opt out of having an escrow account. For conventional loans, you’ll need to have a down payment of 20% or more. FHA loans require all borrowers to have an escrow account.

That said, it’s possible in select instances to pay your property taxes and insurance yourself and lower your monthly payment without having an escrow in place. But doing so means that you’ll have to save for tax and insurance payments on your own. Also, you may incur an added fee for managing your own taxes and insurance. Keep in mind that managing escrow accounts is often a free and convenient service provided by servicers like Rocket Mortgage, so it generally doesn’t make good financial sense to opt out of escrow for your mortgage.

Also be advised that it’s possible to use your escrow account for some expenses and not others. Note too that certain lenders may require escrow for property taxes but not homeowners insurance.

Can you remove escrow from your mortgage?

Yes, you can remove escrow from your mortgage in many cases, but that doesn’t necessarily mean that it’s a good idea to do so for the reasons outlined above. Before attempting this move, you’ll want to speak with your lender and other involved parties to make certain that you meet qualifying criteria.

For instance, certain mortgage lenders require that you maintain a predetermined certain loan-to-value ratio (LTV) of 80% or less in some cases, and an escrow account with a positive balance. You’ll likely need to furnish proof of a current homeowners insurance policy, too.

Also, as alluded to earlier, select loans require escrow accounts to be in place (like FHA loans or those with required flood insurance), so removing escrow won’t be an option in some cases.

The bottom line: Escrow protects both buyers and sellers

Using an escrow account is essential during the home buying process and throughout the course of homeownership.

As you go through the steps of buying a house, it helps protect both buyers and sellers by keeping good faith funds safe and untouched until contractual agreements are met. As you enjoy the benefits of homeownership, it offers a handy and convenient way to budget each month and help you pay your taxes and insurance.

Escrow accounts are sometimes required, others not, depending on the type of loan that you get and your individual financial circumstances.

While it may be tempting to pass on funding an escrow account because it could reduce your monthly bills and mortgage payment, doing so isn’t advised. Escrow provides a handy way to ensure that important bills get paid in timely fashion without having to keep track of due dates or worry about having to make one lump-sum payment.

Interested in learning more about how escrow works and what it takes to finance the purchase of a new home? It takes just minutes to start the preapproval process today with Rocket Mortgage!

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