If you’ve ever purchased a house, or you’re thinking about buying one, you’ve probably heard the term “escrow,” but that doesn’t mean anyone has explained what it means! This article is here to demystify the term and make you more informed and confident, whether you’re buying, selling, or already own a home.
Escrow is an agreement where a third party (someone not involved in the sales transaction) holds on to something of value. This arrangement protects the seller and buyer. If one party doesn’t hold up their end of the contract, the escrow company will make sure the other party is protected from losing out on their investment.
For mortgage escrows, the escrow account is usually held by the lender. The escrow provider will confirm that home inspections, disclosures, and objections are completed or resolved on time for the sale/purchase of home.
What is a mortgage escrow account?
An escrow account—also called an impound account or reserves—holds funds to pay property taxes, homeowners insurance, and anyone else a homeowner designates to pay with these funds. If you, as a homeowner, weren’t able make these payments in total when they’re due, your lender is at risk of the local government putting a lien on the house and collecting taxes due at a sale or foreclosure, or a disaster damaging the house and severely reducing its value without the repairs that insurance would have covered.
Lenders will roll your tax, home loan, and sometimes insurance payments into one monthly sum that you pay. The lender puts the appropriate amount toward your loan payment and the rest into an escrow account that holds onto the tax and insurance money until those bills come due. It’s kind of like a mandatory savings account that ensures you have enough money saved up to pay large tax and insurance bills.
Ultimately, escrow accounts protect the lender and help the homeowner budget for some of their bigger home expenses. It also takes the stress out of having to remember payment dates and amounts because insurance and property taxes will be paid directly and automatically from the escrow account.
Most lenders require an escrow account if you’re a first-time homebuyer and/or you offer less than 20% of the home’s price as a down payment.
Escrow accounts can fall short or have an overage
Because the escrow account holder makes calculations based on your last property tax and homeowners insurance rates, the account can have a shortfall or an overage if those values change. If there’s too little in the account, you’ll get a letter asking if you want to pay the missing amount all at once or split it up and include it in the next year’s 12 monthly payments. If there’s too much in the account, you get a check to cash!
Setting up your own escrow account
If your lender didn’t require you to set up an escrow account, it’s up to you to decide if you want to create one to help budget your money for taxes and insurance. If you decide to set one up on your own, calculate what you’ll need to deposit each month by dividing your property taxes by 12 and adding that amount to your homeowner’s insurance premiums, also divided by 12.
Usually your lender will have an escrow agent that can help you set up an account, or you can search online for other escrow company options. Be sure to account for any escrow service fees that third-party companies might charge.
Going without an escrow account
Even if you’re required to have an escrow account when you first take out your mortgage, there’s a chance you can have your account canceled in the future. For example, when you pay off a certain amount of the loan or after you’ve made 12 consecutive on-time loan payments.
Just remember that if you decide to close or forgo an escrow account, you’ll need to set up some other way of budgeting and saving for property taxes and insurance premiums.