What is an Escrow Account, and How Does it Work?

Posted on Jul 16, 2021

If you’ve been working with a real estate agent to buy a home, you may have heard them talk about putting money "in escrow.” But what exactly is escrow - and what does it mean for your money? Here’s what you need to know.

What is Escrow in Real Estate?

Escrow refers to money that homebuyers put in an account to pay for taxes and insurance. In exchange for higher monthly payments, your lender will pay your taxes and insurance for you, leaving you with fewer bills to worry about/potentially miss.

Note: In some states, like California, escrow (or “in escrow”) can also refer to a property going under contract/under agreement. In this way, escrow is a third, neutral party that helps facilitate the sale. “Being in escrow” is a legal procedure that takes place from the time the seller accepts the offer and lasts until the new owner takes possession of the home. A property can be in escrow for days or weeks at a time, depending on how quickly the conditions of the sale are met and the transaction can be completed. Escrow helps ensure that both the buyer and seller uphold their end of the contract, with the buyer handing over money and the seller handing over the home’s title.

What is an Escrow Account?

An “escrow account” refers to the account that helps manage a homeowner’s insurance and taxes. 

The cost is rolled into your monthly mortgage payment, and lenders are incentivized to offer this because if you were to forget to pay your taxes, it could make it difficult for them to sell your home (in the event of a foreclosure). 

“You’re paying in each month, and then when the bill comes through the money gets taken out,” explains mortgage advisor Casey Hansen. “You’re constantly replenishing it each month by paying your mortgage bill.”

With an escrow account, your taxes and insurance costs can be broken down into monthly payments, rather than potentially having to pay hundreds of dollars on a single bill that comes once a year. Sometimes things like HOA fees can also be added to an escrow account, to further reduce the number of monthly bills you have to deal with. 

Why is Escrow Needed?

Escrow minimizes risk for the lender - if you don’t pay for your home’s taxes, for example, a lien could be placed on the property. If you were to foreclose on the home, a lien would make it more difficult for the lender to resell the home and recoup the money they lent for it. 

Escrow distribution is often required if you are putting less than 20% down. FHA loans, for example, always require escrow accounts. 

“Typically it’s required when somebody’s putting down less than 10% - and with some lenders, it’s required for up to 20% down. It’s a case by case thing,” explains Hansen.

Why is Escrow so Expensive?

Sometimes escrow is one of the largest expenses you’ll deal with when buying a home. The reason your escrow might require a lot of money is that accounts are typically front-loaded - not only will you be paying for many expenses ahead of time, but lenders can also ask you to pay additional monthly payments upfront in order to make sure you can always cover your bills on time. 

As an example, say your bills are as follows:

  • Property taxes: $3,500 a year
  • Homeowners insurance: $1,500 a year
  • Flood insurance: $300 a year 

Total: $5,300

Under federal rules, a lender can ask for the amount of the account, plus two additional months, plus $50 in escrow. So with the above example, you could be required to pay $5,300 + $883 (two months’ amount) + $50, which is $6,183. This can be a hefty sum for homebuyers to cough up right away. 

If excess money is collected for escrow, it will eventually be refunded to you. Similarly, if the amount turns out to be insufficient (such as if your insurance premium goes up) you will need to pay it off or accept a higher escrow fee the next year to make up for it. 

To find out your specific escrow calculation, you’ll need to consult with your lender.

Is Escrow Good or Bad?

The entire point of escrow is to reduce the number of bills you need to pay, making things easier and less complicated - so most homeowners would say it's a good thing.

“Some people would rather manage their own finances and pay their bills on their own - they may not choose to escrow in that case,” notes Hansen. However, most people actually prefer escrow because of the convenience. 

“Most homeowners don’t want to budget for their tax bill each month; they would prefer the convenience of having it rolled into one payment, their mortgage payment,” says Hansen. “A lot of people, even if they could waive escrow, would rather not, because it’s more convenient.”

Further Reading

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