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How does escrow work when buying a home?

Yahoo Personal Finance· Getty Images
7 min read

Escrow is a financial tool shared by the parties involved in a real estate transaction. As a homebuyer, it protects your interests — and those of the seller and the lender.

How does a mortgage escrow account work? Does buying a home require an escrow account, and does it cost more to have one? We'll break down the facts.

Learn more: Is now a good time to buy a house?

In this article:

An escrow account, also known as an impound account, is often established by a neutral third party to hold:

  • Your good faith deposit — collected before closing

  • The funds you deposit into the account the day you close on the house

  • And a portion of your mortgage payment that is deposited monthly

Money is withdrawn periodically from escrow to pay property taxes and homeowners insurance premiums.

Escrow is similar to a savings account; however, in most states, escrow accounts are not required to pay interest.

Simply defined, escrow means to hold an asset, such as money or property, until a condition is met. The third party controlling the account acts as a neutral go-between for the buyer, seller, and, in a home loan scenario, the lender.

The escrow company uses the account to distribute funds to parties with financial interests in the home sale. For example:

  • To the seller, if the purchase agreement requires a good faith deposit or earnest money. The seller will get that money if you back out of the purchase. If not, the deposit will be applied to your down payment.

  • To a builder, if you are buying a house under construction. You will authorize payment from the escrow account as the project progresses and you approve various stages of construction completion.

  • To an insurance company for the payment of homeowners insurance premiums. This protects the lender from a property loss that could lower the value of the home being pledged as collateral.

  • To a taxing authority collecting property taxes.

  • For borrowers who make a down payment of less than 20% on a conventional loan or have an FHA loan, mortgage insurance premiums can be included in an escrow account.

Learn more: What is private mortgage insurance (PMI)?

Of course, not all homeownership expenses are included in an escrow account. Homeowners’ association (HOA) dues may be but often aren't paid from escrow.

It's common for an escrow agent to build a cushion of cash in the account to cover any expenses that might increase over time, such as insurance premiums. You will receive an annual statement containing an escrow analysis of payments and deposits made in the account.

It's true. A mortgage lender can issue an escrow waiver, usually for a fee or in exchange for a higher mortgage interest rate on your loan.

Not having an escrow account means you will have to pay essential expenses such as insurance and taxes yourself. However, you can do so from an interest-bearing savings account rather than from (what in most states) is a non-interest-bearing escrow account. Still, keeping up with these costs on your own isn’t for the faint of heart, and you risk missing a payment.

Certain types of mortgages may not require an escrow account and can include:

  • A "higher-priced" home loan. That is a mortgage with an annual percentage rate (APR) higher than a government benchmark rate. The higher-priced rate varies by loan type, such as a jumbo loan, home equity loan, or home equity line of credit (HELOC).

  • Mortgages with a loan-to-value (LTV) ratio of 80% or less.

  • After a loan has been in effect for a time, which can vary by loan type, lender, or state law.

An escrow payment is any withdrawal from your account that clears a balance due. That may be an annual payment of taxes or the amount due for an insurance premium.

On the other side of the ledger is an escrow refund. That's money that can be reimbursed to you if the escrow account has collected money well over the projected payments that will be made. The escrow agent often asks if you would like to keep the overpayment in the account for future expense increases.

Read more: How much money do I need to buy a house?

An escrow balance is the amount remaining in the account after all payments have been made for the year. The escrow agent will add the remaining balance — with the amounts to be collected over the coming year — to determine if the escrow account will likely cover all upcoming expenses.

If the projection predicts a shortfall, you must make additional payments to the escrow account, increasing your monthly mortgage payment.

Escrow is generally a neutral financial outcome. Money goes in and out with a minimal balance remaining or, hopefully, a minimal additional amount due. While the cost of insurance payments or your tax bill can significantly change over time, the annual swings are not usually drastic. Note the qualifier "not usually."

If the mortgage balance well exceeds the projected amounts due over the next year, you may receive an escrow refund. Or, if you get an escrow waiver and aren't required to fund the account any longer, you will receive the balance remaining. If you refinance your mortgage with a new lender, the escrow agent is required to send you the funds within 20 days. And if you pay off your mortgage, you will receive the escrow balance.

“Being in escrow” is a homebuying term describing the time after a purchase agreement is signed and the good faith deposit or earnest money has been placed in the escrow account. It's a window of time when a home inspection is completed, a mortgage loan is moved through the underwriting process for final approval, and all the details related to the property exchange are attended to before the loan closing.

Removing an escrow account, with the permission of your mortgage lender or servicers, will require you to make insurance and property tax payments on your own. That may be in lump sums annually and could result in a budget hassle. An escrow account smooths out those required expenditures into easy-to-budget monthly additions to your mortgage payment. Either way, you'll still owe taxes and insurance.

There should be no financial impact either way: having or not having an escrow account — unless the escrow agent or company charges substantial escrow fees to manage the account. However, you are not earning interest on the balance in the escrow account. Some financially savvy homeowners establish savings accounts to replace an escrow account and earn interest on the balance.

An escrow account is not really "paid off" unless you are no longer required to pay annual property taxes or ongoing insurance premiums.

The only way to lower your escrow payment is if you can get your homeowners insurance premiums or property tax assessment lowered. You can shop for different insurance. If you find a less expensive provider, it may result in a lower escrow payment. And taxes? Maybe it's less likely, but here are some ways to lower your property taxes.

Your escrow payment, and as a result, your mortgage payment, can go up if any item paid by your escrow account becomes more expensive. It's common for insurance premiums and taxes to rise over time. That means your escrow payment will likely increase slowly over time.

Your escrow account can be closed if your lender approves a waiver or if you pay off your mortgage. In either case, you will be responsible for making the payments for property taxes and homeowners insurance.

This article was edited by Laura Grace Tarpley