MORTGAGE MATTERS

3 min read

ellipse icon

Aug 2022

What Is an Escrow Account, and How Does It Work?

filled check icon

WHAT YOU'LL LEARN

check icon

What is escrow?

check icon

How does escrow help my home purchase and mortgage?

check icon

Do I really need to pay escrow?

filled check icon

WHAT YOU'LL LEARN

check icon

What is escrow?

check icon

How does escrow help my home purchase and mortgage?

check icon

Do I really need to pay escrow?

If you’re unsure what “escrow” means, you’re not alone! But in a nutshell, it’s a really helpful tool.

During the homebuying process, several other transactions take place besides your new mortgage. Escrow means to temporarily give that money to a neutral party for safekeeping. That way, the funds for things like deposits, taxes, and homeowners insurance are kept safe and ultimately paid to the right party. Let’s see how they work.

What Is an Escrow Account?   

Well, really there are two escrow accounts. The first happens during the homebuying process and is handled by a “closing agent” or “settlement agent.” This account protects funds like your good faith deposit (aka earnest money). They’re held in escrow to make sure everyone follows through with the contract. If the sale falls through because you walk away, the seller usually gets to keep the money. But if the purchase is successful, the deposit will be applied to your down payment.

The second escrow account is managed by your mortgage servicer after you close on the home. This account is ongoing and holds funds for your property taxes, home insurance, and private mortgage insurance (PMI) until they’re due to their respective agencies. To ensure that they’re paid, on time, these annual lump sums are divided by 12, and that portion is included with your monthly mortgage payment.

After closing, most mortgage companies will sell your mortgage to an outside servicer, who’ll manage your payments for the rest of your loan’s term or until it’s sold again. These sales are very common and don’t affect your loan payments, just where they’re sent.

Why is this escrow account important? First, it keeps you from having to pay these amounts in a lump sum up front when you buy the home. And, you don’t have to manage all the different due dates and amounts.

Second, your lender needs to make sure these critical payments are made. If you don’t pay your tax bill, the IRS could ultimately foreclose on your home, costing the lender money. And if your homeowner’s policy isn’t up to date and a fire occurs, the damage to or loss of the home could also be costly to the lender.

Escrow Cushions

Your lender may require an “escrow cushion” of two months as allowed by state law. Taxes and insurance can go up each year, and the cushion covers unexpected costs. If the estimated cushion is higher than actually needed, the extra money will be refunded to you. If you don’t have enough money, the servicer will still advance the funds on your behalf and replenish the account as you continue to make your monthly mortgage payments.

Watch for Your Annual Analysis

Your servicer will perform an annual escrow analysis to make sure you have enough money to cover your costs. They’re required by law to send you a letter in advance of any changes explaining their calculations so you can adjust your budget for a higher monthly mortgage payment. You’ll also have the option to pay the shortage in full if you prefer. In the meantime, keep an eye out for copies of your insurance and tax bills so that any change in payments won’t come as a surprise.

Can I Pay Another Way?

Finally, if you really, really like managing all your own finances, have a Conventional loan, and your loan-to-value (LTV) ratio is 80% or less of the home’s value, many lenders will let you skip escrow and pay your own taxes and insurance (usually for a small fee). But Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) loans require that you have an escrow account for these expenses.

If you have any questions about escrow, feel free to contact us!