Mortgage 101

What Is Escrow and How Does It Work?

Published on: May 10, 2022

what is escrow

When you make an offer on a home or take out a mortgage, you might need an escrow account to set aside money for certain payments and ongoing costs. But what is escrow in real estate and how exactly does it work?

Escrow is an essential part of buying a home, both for holding money during the home purchase and paying for ongoing costs after closing, such as property taxes and homeowners insurance. Understanding the definition of escrow and how an escrow account works can better prepare you for what to expect.

What is escrow in real estate?

Escrow generally means having money or other valuables kept safely with a third party until certain conditions are met. When it comes to real estate, escrow comes into play when a potential homebuyer makes an earnest money deposit to back up a purchase offer. The money is deposited into an escrow account to protect both the buyer and seller. This arrangement allows both parties to be sure the money is safely held until the sale is either completed or cancelled.

Once you’ve purchased the home, your mortgage servicer often requires you to use an escrow account. This helps ensure you’re setting aside enough money every month for real estate taxes and homeowners insurance bills that typically come due once or twice a year.

How does escrow work?

So exactly how does escrow work? It’s easier to understand if we break it down into two parts: during the homebuying process and after closing.

Escrows for homebuying vs. escrows for taxes and insurance

You’ll hear about escrow during two phases of your home purchase:

  • Prior to closing on a home sale.
  • After closing, as part of your monthly mortgage servicing.

When buying a home, your earnest money deposit will be placed into an escrow account, usually with a title company, real estate broker, or law firm. Think of earnest money as a good-faith showing to the seller that you’re serious about following through with the transaction. When the mortgage process is complete and you close on your home, the earnest money is applied to your down payment and closing costs.

Once you own the home, your lender or mortgage servicer will establish an escrow account for you. When you make your monthly payments, a portion of the money will go into escrow. It will be held there until it is needed to pay for certain home-related expenses, such as property taxes and homeowners insurance.

Do I need an escrow account?

As a homebuyer, an escrow account has several essential functions:

  • Backs up your purchase offer.
  • Offers safekeeping for earnest money.
  • Provides flexibility for the buyer and seller.

Putting your earnest money into escrow demonstrates to the seller that you’re making a serious offer to buy the home. Escrow keeps that large sum safe, protecting both parties while the purchase details are worked out.

As a homeowner, an escrow account helps you with ongoing home-related costs. Escrow accounts:

  • Are sometimes required by law or by the lender.
  • Break down large annual payments into manageable monthly amounts.
  • Ensure property taxes and homeowners insurance premiums are paid on time.

An escrow account is often required when your down payment is less than 20%, but this may vary by lender. Since the house acts as collateral to secure the mortgage debt, the lender has a strong interest in making sure you pay all property taxes and insurance premiums. As a result, your lender may require an escrow account to pay these bills on time to avoid liens on the home.

Even when an escrow account isn’t required, you may want to request one anyway. An escrow account helps you, as the homeowner, better manage these large bills that can add up to thousands of dollars annually. By spreading out the payments over the course of a year, you may be able to better budget and anticipate housing expenses long term.

Who manages the escrow account and how much do they charge?

During a home purchase, a real estate agent, law firm, or title company will typically manage the escrow account. The escrow fee may range from 1% to 2% of the home’s sales price and will be included in your closing costs. On a $300,000 home purchase, that means you can expect to pay $3,000 to $6,000 in escrow fees. To keep your closing costs — including escrow fees — to a minimum, be sure to compare charges when shopping for a mortgage and ask your lender if any fees can be lowered or waived.

After closing, your mortgage servicer will establish an escrow account for your property taxes and insurance premium payments. The servicer, which may not end up being the same lender that closes your loan, will determine the amount you’ll pay each month. The escrow payment will be calculated based on estimated property taxes, homeowners insurance premiums, and any other charges you’ll have to pay. The lender or servicer has the right to require you to pay an extra “cushion” to be held in the escrow account, just in case the bill amounts change. The cushion added to your escrow account is typically two months’ worth of escrow payments.

Escrow account FAQs

Here are some common questions about the meaning of escrow and how escrow works:

How long do I pay escrow for?

You may have the option to stop paying into an escrow account once you have built up at least 20% equity in your home or once the mortgage balance has reached less than 80% of the original principal amount. At that point, if you’d rather handle your tax and insurance bills yourself, you can ask the mortgage servicer if you qualify to cancel the escrow account. The lender may decide to allow it, since it will be in your self-interest to make sure those important bills are paid regularly.

Why did my escrow payment go up?

Your monthly payment amount can change from time to time. It may go up, even if you have a fixed-rate mortgage. The most common reasons for this are increases in your property tax rate or homeowners insurance premium.

How can I lower my escrow account payments?

You can try disputing your property tax bill if you think it is too high, by contacting your county assessor. Some savvy homeowners routinely challenge their assessments to keep their taxes as low as possible. Another way to lower your escrow payments is to cancel any private mortgage insurance, if you’re eligible. If you have mortgage insurance and have built up at least 20% equity in your home, you can ask to cancel the insurance to lower your monthly payment amount — although it should be automatically removed by the time your mortgage balance reaches 78% of the purchase price.

Buying a home and have questions about your escrow account? Talk to a local Finance of America Mortgage Advisor today to learn all about the homebuying process.

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