this pic describes the thought process of understanding escrow

What Is Escrow and How Can It Help You Buy a Home?

TLDR

What You Need To Know

  • You can use an escrow account to manage funds before you close on your home and to pay for taxes and insurance afterward
  • You may be entitled to an escrow refund if your balance exceeds the amount that the escrow company is required to hold
  • If you use an escrow account for property taxes and insurance, the lender is required to maintain a minimum balance that includes 2 monthly mortgage payments plus $50

Contents

“Escrow is the safe third party that holds the money until all the red tape is done.” – Chrishell Stause, Selling Sunset

As you dip into the home buying waters, you may hear the term “escrow” being thrown around. As a homeowner, you’ll be set up with a mortgage escrow account, which will serve you throughout the life of your mortgage. In the early stages of buying a home, an escrow account is used to hold your down payment until closing.

Understanding how escrow works can help you navigate the home buying process and budget for payments once you get your mortgage.

What Is Escrow?

When you make a friendly wager, you may ask a neutral friend who’s not involved in the wager to hold onto the money for you. Escrow is the legal version of that neutral friend. It’s a responsible third party that temporarily holds onto money during the home buying process and releases it when a particular condition – or set of conditions – has been met.

What Is an Escrow Account?

An escrow account is essentially a savings account that is managed by a bank or title company (we’ll get into that more later). The account is used to set money aside, ensuring that the soon-to-be homeowner can meet their financial obligations.

So, why do these accounts even exist? In real estate, you have two different types of mortgage escrow accounts:

  • Mortgage escrow accounts for home buying
  • Mortgage escrow accounts for taxes and insurance

Mortgage Escrow Accounts for Home Buying

When you’re buying a home or making another real estate transaction, you may need to make a good-faith deposit (aka earnest money deposit). This deposit is placed into your escrow account to show that you intend on completing the deal. It usually equals 1% – 2% of the home sale price.

Why earnest money is held in escrow

Earnest money signals to the seller that you’re serious about buying the home. Once the good-faith deposit is in the account, the seller can’t accept any other offers. After you close on the home, the deposit can be applied toward your down payment or your closing costs.

Getting escrow money back before closing

There are many scenarios when a buyer can get their money back from escrow:

  • If financing falls through
  • If undisclosed problems are discovered during the home inspection or title search
  • If a home appraisal is significantly lower than the sale price

But, if you, as the buyer, are responsible for the contract falling through, the seller usually gets to keep the money, so work with your real estate agent to ensure that you’re meeting all your obligations.

Mortgage Escrow Accounts for Taxes and Insurance

After you close on your home, your lender or loan servicer will set up a new escrow account for your taxes and insurance. This type of escrow account is used to collect and manage the funds needed to meet specific obligations throughout the life of your mortgage. An escrow account covers:

  • Estimated property taxes
  • Insurance premiums (including homeowners insurance and mortgage insurance)

Escrow accounts don’t cover:

  • Utility bills
  • Homeowners association fees
  • Supplemental tax bills

How do escrow payments work?

What you pay to your escrow account depends on the cost of your property taxes, homeowners insurance and mortgage insurance. Since these expenses are paid annually or semi-annually, you should aim to save a fraction of the total cost each month.

Say your property taxes are $5,000 a year and your homeowners insurance is $1,000. That’s $6,000 for the year. When you divide that $6,000 by 12 months, it comes up to $500 a month. That’s what you (or your escrow account manager) should aim to set aside each month.

How does your mortgage escrow account work?

To ensure that you can cover your property taxes and insurance payments, you must maintain a minimum balance in your escrow account. According to federal regulations, your escrow account should have enough money to cover:

  • Annual insurance and property tax bills
  • A cushion of two extra monthly payments
  • An extra $50

What are escrow adjustments and refunds?

Let’s say your property taxes are reassessed or your mortgage premiums are readjusted, and the amount you need to pay goes up. Your mortgage lender may increase your escrow payments to ensure that there’s enough money in your account to cover your new payments.

If the amount you need to pay goes down, your payments may go down – and you may even get a refund!

The Pros and Cons of Using Mortgage Escrow Accounts 

Using a mortgage escrow account to buy a home is usually the standard operating procedure. But when it comes to using a mortgage escrow account to cover property taxes and insurance, you may be able to opt out.

Opting out of using an escrow account will make your monthly mortgage payment lower, but you’ll have to make separate payments for property taxes and homeowners insurance.

Consider the pros and cons of opting out and opting in:

Pros

  • Lower interest rate: If you decide to go with a mortgage escrow account, your lender may offer you a discount on your interest rate or closing costs.
  • Worry-free payments: With a mortgage escrow account, you won’t be left wondering how much you need to set aside or if you set aside enough money to cover your property taxes. By using an escrow and letting the lender manage payments, you can save yourself the stress of missing payments or coming up short on funds.

Cons

  • Upfront payment: When you set up a mortgage escrow account, you might pay upfront to cover several months of property taxes. That can add to your closing costs when you buy your home.
  • Loss of interest: While the money is sitting in an escrow account, it earns interest like any other savings account. That interest goes to the lender.
  • Additional cost: Many mortgage servicers charge a waiver fee for opting out of escrow payments. Check to see if that’s the case before deciding to make payments on your own.

Who Manages the Account?

While you’re in the middle of the home buying process, your real estate agent (or the seller’s real estate agent) will set up an escrow account through a title company or a bank. 

Once you’ve closed on your new home and you start making mortgage payments, your mortgage lender (or loan servicing company) is responsible for setting up an escrow account to handle your taxes and insurance.

The lender or servicer deposits a portion of your mortgage payment into the escrow account. When your property taxes or insurance payments are due, the lender withdraws money from the escrow account to make the payments.

Final Thoughts on Escrow

Escrow is a lot more than a six-letter word, it’s a major part of the home buying process. And it helps ensure that you can meet all the financial obligations of your mortgage over the life of your loan.

Opting Out of Escrow

Most homeowners find escrow accounts to be convenient. They can help make your monthly payments more manageable.

If you’d prefer to not make an escrow payment, there are circumstances where you can choose to opt-out. This will make your monthly mortgage payment lower, but you’ll have to make separate payments for property taxes and homeowners insurance. Many mortgage servicers charge a premium for opting out of escrow payments, so please check before deciding to make the payments on your own.

Final Thoughts on Escrow

While escrow may not be a word you use every day, it’s a helpful part of the home buying process. And it helps ensure that you can meet all the financial obligations of your mortgage.

ICYMI

In Case You Missed It

  1. If you deposit earnest money into escrow, you can get it refunded if the sale doesn’t happen and it’s not your fault

  2. You may be entitled to an escrow refund if your balance exceeds the amount that the escrow company is required to hold

  3. Using an escrow account over the life of the mortgage is optional; however, it is usually convenient for most homeowners and may actually cost more to not use an escrow account

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