Escrow: What Is It And How Does It Work?
December 22, 2023 8-Minute Read
Author: Victoria Araj
If you’re buying a home, you’ll probably hear the word “escrow” used in a few different contexts. Let’s look at what escrow is, how it works and how it can benefit you as a home buyer, seller or homeowner.
What Is Escrow?
Escrow is a legal arrangement in which a third party temporarily holds money or property until a particular condition has been met – such as the fulfillment of a purchase agreement.
How Does Escrow Work?
It’s used in real estate transactions to protect both the buyer and the seller during the home buying process. Throughout the term of the mortgage, an escrow account will hold funds for taxes and homeowners insurance.
What Is An Escrow Account?
In real estate, escrow is typically used for two reasons:
- To protect the buyer’s good faith deposit, so the money goes to the right party according to the conditions of the sale
- To hold a homeowner’s funds for property taxes and homeowners insurance.
Because of the different purposes served, there are two types of escrow accounts. One is used during the home buying process, while the other is used throughout the life of your loan.
Escrow Accounts For Home Buying
When you’re buying a home, your purchase agreement will usually include a good faith deposit – (also known as earnest money). This deposit shows the seller that you’re serious about purchasing the home. If the contract falls through due to the fault of the buyer, the seller usually gets to keep the money. If the home purchase is successful, the deposit will be applied to the buyer’s down payment.
To protect both the buyer and the seller, an escrow account will be set up to hold the deposit. The good faith deposit will sit in the escrow account until the transaction closes.
Sometimes, funds are held in another type of escrow account past the completion of the sale of the home. This is called an escrow holdback. There are many reasons an escrow holdback may be needed. For example, perhaps you agreed that the seller can stay in the home an extra month, or there are outstanding bills on the home that the seller is responsible for (a water bill, for example).
If you’re building a new home, money may remain in escrow until you’ve signed off on all the work. Once the conditions are met, the money will be released to the right party.
Escrow Accounts For Taxes And Insurance
After you purchase a home, your mortgage lender will establish an escrow account to pay for your taxes and homeowners insurance. Each month, your mortgage servicer takes a portion of your monthly mortgage payment and holds it in the escrow account until your tax and insurance payments are due.
The amount required for escrow is a moving target because your tax bill and insurance premiums can change from year to year. Your servicer will determine your escrow payments for the next year based on what bills they paid the previous year. To ensure there’s enough cash in escrow, most lenders require a minimum of 2 months’ worth of extra payments to be held in your account.
Your lender or servicer will analyze your escrow account annually to make sure they’re not collecting too much or too little. If their analysis of your escrow account determines that they’ve collected too much money for taxes and insurance, they’ll give you what’s called an escrow refund.
If their analysis shows they’ve collected too little, you’ll need to cover the difference. You may be given options to make a one-time payment or increase the amount of your monthly mortgage payment to make up for a shortage in your escrow account.
Who Manages An Escrow Account?
Escrow accounts may be handled by a variety of third parties, including an escrow company, escrow agent or mortgage servicer. Where you are in the process will determine who manages the account.
Escrow Companies And Escrow Agents
The escrow company not only manages the buyer’s deposit, but they may also be responsible for holding the deed and other documents related to the sale of the home.
Because the escrow company is working for both the buyer and the seller in the real estate transaction, the fee for their services is usually split evenly between the two parties.
Your mortgage servicer manages your mortgage, from closing until you pay off your loan. Mortgage servicers are responsible for collecting your mortgage payment, maintaining the records of payments and managing your escrow account.
Your mortgage servicer is sometimes your originating lender – but not always. Sometimes, lenders sell the servicing rights to your loan. It’s a good idea to know ahead of time whether your lender typically services their own loans. Not all mortgage servicers provide the same level of service.
With your mortgage servicer taking care of your escrow account, you don’t have to worry about your tax or insurance bills – your servicer will make sure they know who to pay, and when.
The only exception is if you change insurance providers or policies. You will need to provide the new policy information to your servicer.
The Benefits Of An Escrow Account
The biggest benefit of having a Rocket Mortgage® escrow account is that you’ll have peace of mind knowing 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 is key to protecting your deposit during a home sale. For example, say you have a purchase agreement, but the sale falls through due to a problem found during the home inspection.
If you’d given your deposit directly to the seller, there’s a chance they wouldn’t return your deposit. But since the deposit is being held by a third party, you can be confident it will be returned according to your agreement.
An escrow account takes the pressure off you to come up with a lump sum to cover taxes and insurance. Since you’re paying for your taxes and insurance throughout the year, the payments are much more manageable.
Another bonus is that you don’t have to keep track of all the different due dates. When your tax bills and insurance premiums are due, your mortgage servicer will make sure those bills are paid on time, every time. That way, you’re not responsible for any late payments. Your servicer will even cover bills for you if your escrow account is short on funds – but, as mentioned above, you’ll be responsible for making up the shortage later.
Lenders have a vested interest in making sure your property taxes and insurance get paid:
- If your tax bills don’t get paid, the tax authority could put a lien on your home – which could end up costing the lender money if the tax authority chooses to foreclose.
- If your homeowners insurance coverage lapses, significant damage to or loss of the home could lead to extreme loss of value of the home.
Having an escrow account on the loan allows the lender to ensure the bills get paid.
The Disadvantages Of An Escrow Account
Although there really aren’t any disadvantages of having a mortgage escrow account, here are some that could be considered as such:
Higher Monthly Mortgage Payments
As stated before, an escrow account is funded through your monthly mortgage payment, making your monthly bill higher than it would be without escrow. But this also means that you don’t have to pay your taxes or insurance in a lump sum when they are due, so this is hardly a disadvantage when you think about it.
Lower Escrow Estimates Than Actually Required
Again, the amount needed for your escrow depends on your property taxes and homeowners insurance costs, which can change from year to year. Your servicer will determine the amount needed based on the previous year’s bills. But here’s the thing: When you first move into your home, your property is reassessed for tax purposes. This may cause your property taxes to increase substantially, especially if the home value has risen. When a servicer estimates the escrow, they may not be able to predict an increase in your property taxes.
Because of this, your escrow may come up short. If that happens, you’ll have to pay the difference with an increase in your monthly escrow payment. On the flip side, if there’s any money left over in your escrow after paying the taxes and insurance for the year, your servicer will refund you the excess funds.
Changes To Your Monthly Payment
Escrow is reassessed each year and, depending on if you were short or had excess money, your servicer will come up with a new estimate for the year. If you’re short, your mortgage payment will go up because the estimate will increase. This higher estimate is an effort to prevent another shortage. If you had too much money in the account, your mortgage payment may go down and you’ll receive a refund each year.
What Escrow Accounts Don’t Cover
Escrow accounts don’t cover all the expenses related to homeownership. Your lender or servicer won’t collect money to pay your utility bills or homeowners association (HOA) fees, for instance.
Supplemental tax bills also aren’t covered by escrow accounts. These are one-time tax bills that are issued due to a change in ownership or new construction.
Do You Need An Escrow Account?
It may be possible to pay for property taxes and insurance yourself instead of using an escrow account. Doing so will lower your monthly mortgage payment, but you’ll have to save for tax and insurance payments on your own. Plus, you may incur a fee for managing your own taxes and insurance. And because managing escrow accounts is a free service provided by servicers such as Rocket Mortgage, it doesn’t make financial sense to opt out of escrow for your mortgage.
Truthfully, not everyone even has an option for opting out of an escrow account on their loan. Escrow accounts are a requirement on certain loans. 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.
It’s also possible to use your escrow account for some expenses and not others. Sometimes, lenders require escrow for property taxes but not homeowners insurance.
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Escrow Process FAQs
Below, you can find some frequently asked questions to help you better understand escrow and the process.
What is an escrow balance?
Your monthly payments are split into three parts: principal, interest and escrow. Your escrow balance allows for the company that services your loan to take money out of your escrow balance to pay for taxes or insurance.
What is an escrow agreement?
An escrow agreement is the terms and conditions in a contract between the parties involved and the responsibilities they hold. The escrow agreement will usually involve an independent third party, referred to as an escrow agent.
What does it mean to be in escrow?
To be “in escrow” is a type of legal holding account. These items (money or property) can’t be released until all conditions are met between both of the parties.
The Bottom Line: Escrow Protects Both Buyers And Sellers
Escrow is an important part of purchasing a home. It protects buyers and sellers during home sales, and it offers a convenient way for you to pay for your taxes and insurance.
An escrow account is sometimes required, and sometimes it’s not. It depends on the type of loan you get, as well as your financial profile. It may be tempting to go without an escrow account because it could mean a lower monthly mortgage payment – but escrow provides peace of mind by removing your responsibility of making sure those important bills get paid and having to pay them in one lump sum when they are due.
If you feel ready to begin the home buying process, get approved with Rocket Mortgage today.
*Rocket Mortgage has won more awards than any other brand in the J.D. Power U.S. Mortgage Servicer and Origination Satisfaction Studies from 2002-2022 (Origination) and 2002-2023 (Servicer). Visit JDPower.com/Awards for more information.
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What Is An Escrow Waiver And Should You Get One?
Home Buying - 7-minute read
Miranda Crace - February 02, 2024
When you make your mortgage payment, you’re likely paying extra into escrow for your insurance and taxes. Find out whether an escrow waiver is right for you.
Escrow Fees: What They Cost And Who Pays Them
Home Buying - 3-minute read
Andrew Dehan - June 09, 2023
Escrow fees ensure a secure exchange of funds between buyer, seller, lender and other parties. Read on to learn what they cost and who pays for them.