What Is Escrow and How Does It Work?

For some homebuyers, an escrow account is an important piece of a mortgage.

Escrow is a financial arrangement where a neutral third party holds money belonging to others and releases it under certain contractual conditions.

Escrow is used in many contexts, but it's critical in real estate, where there are two different ways escrow is used:

1. During the home buying process to hold a deposit
2. After becoming a homeowner to cover property tax and insurance payments

This guide will explain escrow meaning, the different kinds of escrow accounts involved in real estate transactions, and how they can impact you as a homebuyer or homeowner.

What Is an Escrow Account?

Escrow is a broad term used to describe any situation where a neutral third party helps in a transaction between two or more other parties. The neutral third party holds money or assets to help make sure both parties live up to any requirements of the transaction. The money is released when the required conditions are met.

Escrow can be used when a buyer makes an offer on a home. The buyer's deposit is put into escrow to make sure they are serious about buying. If a buyer fails to follow through on the purchase without a legally valid reason to back out, the money in escrow can be defaulted to the seller.

Escrow accounts are also used to hold money that homeowners pay monthly to cover annual property taxes and homeowners' insurance bills. Many mortgage lenders require borrowers to add the cost of these expenses to their monthly mortgage payments. When the insurance or property tax bills are due, the money is paid out of your escrow account.

Escrow Account to Buy a Home

When you're buying a house, you typically need to make an earnest money deposit (usually 2% of the sale price). This shows you're serious about making the purchase. The earnest money goes into an escrow account.

Earnest money in an escrow account protects the seller, who must change their listing from active to pending after accepting an offer. The seller keeps the money in the escrow account until closing, when the funds are credited toward mortgage costs.

Keeping the money in escrow also protects the buyer. Buyers usually make their offer contingent upon, or conditioned upon, certain things happening, such as the house passing inspection. If those conditions aren't met, the buyer can get the money back.

The third party holds the money until the transaction ends and then delivers it to the right person based on how the transaction is resolved.

Escrow Account to Pay Taxes and Insurance

Escrow accounts are also used after you buy a home.

When you own a home, your lender requires you to have valid homeowners' insurance to protect the house (since the house is collateral guaranteeing the loan). Premiums are often paid once a year and can cost thousands of dollars.

You also pay property taxes when you own a house. Again, payments are often made once a year and can be very expensive.

Lenders want to make sure the money to cover annual taxes and insurance on your home is available when needed. That's why money is collected monthly, and all bills are paid on your behalf. Otherwise, the house could become uninsured or even be taken in a tax foreclosure sale.

How Does an Escrow Account Work?

All escrow accounts involve neutral third parties holding money, but they work differently depending on which kind of escrow account you're talking about.

If you have put earnest money in an escrow account when you are buying a home, it stays there until one of three things happens:

• The sale of the home goes through, and the seller gets the money at closing.
• The buyer walks away for no reason, and the seller gets the money when the contract is cancelled.
• The buyer walks away for an allowable reason and gets their money back when the contract is cancelled.

On the other hand, if your money is going into an escrow account to pay property taxes and insurance, you simply send in the required amount of money with your monthly mortgage payment and some of that money is deposited into the escrow account.

Say, for example, that your property taxes are $5,400 per year and your home insurance costs are $1,200 per year. You need a total of $6,600 to cover these costs. This amount is divided by 12, and you pay $550 extra per month on your mortgage payment for these bills. That money goes into escrow until it's needed.

When you initially close on your home, your lender may also require you to fund your escrow account to get it started. Keep in mind, since your payments into escrow are based on the cost of taxes and insurance, this payment can also go up (or down) over time if your insurance premiums or taxes increase or if you get a deal on cheaper insurance.

If your escrow payments change, the cost of your mortgage changes. If property taxes go up to $1,500 in our above example, you'd need $6,900 instead of $6,600. The extra tacked onto your mortgage would total $575 per month or $25 more per month.

Benefits of an Escrow Account

There are some big benefits to escrow accounts, both during the sale process and when you're covering your property taxes and insurance.

During the buying process, making a larger earnest money deposit can help you get your offer accepted since it gives the seller more peace of mind. Of course, buyers don't give this money directly to the seller directly because they might have to walk away from the home purchase for a legitimate reason.

With a neutral third party holding the funds, sellers can feel confident in withdrawing their home from being an active listing, because they have the earnest money to ensure the buyer doesn't just walk away on a whim.

Paying into escrow for property taxes and insurance also benefits you in a few important ways, including the following:

• It ensures property taxes are paid on time. Nonpayment of property taxes can lead to added costs and potentially even your home getting a lien on it or being taken and put up for sale to pay the taxes. Paying money into escrow over time ensures you have the money ready when the property tax bill comes so you don't have to worry about it.
• It offers the convenience of adjusting annually. Your escrow payments adjust once a year to account for changes in insurance premiums and taxes. Having predictable, steady payments throughout the year helps make sticking to a budget easier.
• It allows you to avoid having to come up with a lump sum payment. By forcing you to save during the year, you aren't left scrambling to come up with several thousand dollars in a short time to pay for your taxes and insurance.

Some lenders require escrow, but others allow you to waive it. Even if you can waive it, think seriously about putting money into your escrow account anyway to smooth out your monthly expenses and make budgeting work better.

Drawbacks of an Escrow Account

There is no real disadvantage of an escrow account when you're buying or selling a home, other than buyers must tie up some money for a little while during the buying process. Since you're probably using downpayment money for your earnest money deposit anyway, that's not a big con.

As far as the escrow account you pay your property tax and insurance payments into, there are some disadvantages, including:

• Making higher monthly payments. Some people don't want their mortgage payment to be higher each month and would prefer to just make a lump sum payment instead. If you get a big work bonus once a year, for example, you may prefer to just use that for taxes and insurance rather than being forced to make higher payments all 12 months of the year.
• Tying up your money. The money you put into an escrow account can't be used for other things. It's stuck in that account, sometimes for a long time, while you wait for the tax and insurance bills. If your taxes and insurance premiums are due in December but you made payments starting in January, you'll be giving up the use of your money almost a year earlier than you need to.
• Potential escrow shortages. If your property taxes or insurance go up a lot after your annual payments are calculated, there may not be enough money to pay them. You could end up with an escrow shortage. You'll have to come up with this extra money either all at once or by making slightly higher monthly payments over time.
• You don't earn interest. Typically, you aren't paid any interest on the money that you put into your escrow account. If you saved yourself and kept the money in a high-yield savings account, you'd be able to earn interest on the money while you waited for the tax and insurance bills to come.

These downsides are almost always outweighed by the benefits, but they are still worth considering if you can opt in or out of escrow.

Escrow Account FAQs

Still want to know more? Here are answers to frequently asked questions about escrow accounts.

Is an Escrow Account Required?

You will always have to have escrow on certain kinds of loans, such as FHA loans, but your lender may offer the option to waive escrow on conventional loans (loan not backed or guaranteed by the government). Lenders consider many factors when deciding whether to waive escrow, including the loan type and loan to value ratio. There may also be a fee.

Can You Remove Escrow from Your Mortgage?

You may be eligible to remove escrow from your mortgage depending on loan type, your lender's policies, and your consistent payment history. Ask your lender what is required to remove escrow from your mortgage.

What Is an Escrow Shortage?

An escrow shortage occurs if there is not enough money in your escrow account to pay the property taxes or the insurance bill. If your property taxes or insurance are higher than the estimated amount for the year, you may have an escrow shortage. You'll have to correct this by making either a large lump sum payment or increasing your mortgage payment to make up for the shortfall over time.

What Is an Escrow Refund?

An escrow refund occurs when you have a surplus of money in your escrow account. This can happen if your property taxes or homeowners insurance costs decline, or if you pay off or refinance your mortgage with money still in your escrow account. Your lender will send you the extra money back. Typically, this happens automatically and you don't need to request it.

The Bottom Line on Escrow Accounts

Escrow accounts can be very helpful when buying a home, and in making sure your property taxes and insurance are paid.

While not everyone wants or needs to pay their property taxes and insurance into an escrow account, you should talk with your lender about whether this is required or is an option for you.

Freedom Mortgage offers flexible loan options with and without escrow accounts. Reach out to learn about what money-saving loan options are right for you and to take the first step to getting a mortgage to buy the home you've been dreaming of.