How does an escrow account work?

Pay taxes and insurance bills as part of your monthly mortgage payment.

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Key Takeaways

  • Instead of paying for homeownership costs separately, you set them aside in an escrow account

  • Escrow funds are used to pay property taxes and insurance bills

  • Open an escrow account with your mortgage lender, which typically services the account

  • Escrow accounts give borrowers the convenience of a bundled monthly payment

Taking out a mortgage comes with many costs besides the principal and interest. Homeowners need to pay property taxes, homeowners insurance, and often mortgage insurance, too. While you can pay for these costs directly, many people use an escrow account instead. In fact, it’s often required for many borrowers.

The way it works is you fund the escrow account on a monthly basis, and the escrow account makes the appropriate bill payments on your behalf. The escrow account is serviced by your mortgage lender, making for a convenient process. Because so much money is changing hands when you make a mortgage payment, escrow accounts ensure that the money is always there and that it gets to the right recipients. We’ll talk about how escrow accounts work and what you can use them for.

What is an escrow account?

With an escrow account, a third party holds your money and makes payments for you. The mortgage company (your lender) contracts with an escrow company, who will collect your payments on behalf of the mortgage company.

Escrow accounts provide borrowers with a simple way to pay for different costs related to homeownership. (We’ll dive into each of them in the next section.) Rather than paying bills on your own, you put money into an escrow account. When the payment is due, the escrow agent will handle the transactions and pay the necessary bills.

How do you actually put money in escrow? You don’t transfer money into an escrow account the way you would with a bank account. The money for funding the escrow account is simply added to your monthly mortgage payment. The benefit for borrowers is peace of mind and convenience. You don’t have to worry about multiple bills, just one monthly payment. In some states, the money in an escrow account may earn interest.

Escrow accounts also provide assurance to lenders that you’ll pay your bills on time. (Not paying your bills could lead to foreclosure). Escrow accounts are usually required, particularly for buyers who make a down payment of 20% or less. FHA loans also require escrow accounts. If you choose to pay taxes and insurance on your own, you may need to get an escrow waiver from your lender.

What are escrow funds used for?

Escrow funds are used to make payments for the following:

Property taxes

States and local governments levy taxes on all land and real estate. These taxes are assessed based on the property’s market value — though not the entire value. If you fail to pay your property taxes, then a tax lien may be placed against your property.

Learn more about property taxes.

Homeowners insurance

Homeowners insurance protects your house from certain covered perils. It’s an essential part of owning a home that’s almost always required by the lender. Insurance premiums are based on many factors, including the size of the home, location, and.

Learn more about how to buy homeowners insurance.

Private mortgage insurance

Homebuyers don’t take out a mortgage loan for the entire sale price of the house. They typically have to pay some money upfront, called a down payment. When you put down less than 20% on a conventional loan, mortgage lenders require you to pay mortgage insurance (PMI). FHA loans have their own type of mortgage insurance with different down payment requirements. The insurance premiums are calculated as a small percentage of your monthly mortgage payment and you can stop paying them once you have enough equity in your home (when your loan-to-value ratio reaches below 80%).

Learn more about how mortgage insurance works here.

Earnest money deposit

Another use of an escrow account involves the buyer and seller in a real estate transaction. During the homebuying process, the buyer usually ends up paying the seller a lump sum of money called a good faith deposit or earnest money deposit to take the home off the market. Earnest money deposits typically start around 1% of the purchase price, but may go up to as much as 10%.

Instead of paying the seller directly, the money goes into the buyer’s escrow account and is later applied towards closing costs. (Your real estate agent can tell you about how much the deposit should be and guide you through this process.)

If you’re a renter, your security deposit may similarly be held in the landlord’s escrow account.

What you cannot use escrow accounts for

The money in an escrow account typically can’t pay for homeowners association fees, utility bills, or closing costs which are paid at the end of the mortgage process. Escrow funds can’t be used toward legal liabilities related to your home either, like if someone gets hurt on your property. (Personal liability coverage can however help protect you from these claims.)

How much money goes in an escrow account?

The lender will look at the annual property tax estimate and the annual homeowners insurance premiums and divide it by 12 to calculate the monthly payment. This is how much you pay to fund the escrow account.

To err on the side of caution, the escrow account servicer often requires a minimum balance of one or two months’ worth of escrow payments, in case there are any increases in property taxes or if your homeowners insurance rates went up.

If your homeowners insurance premiums have increased, you might consider reshopping your policy. Policygenius can help you compare quotes.

The account servicer usually reassesses bills and payments on yearly basis, but if you notice that taxes or insurance premiums have changed, you can call them and let them know.