When you make a friendly wager or pool your money, you may ask another neutral friend to hold onto that money for you. Escrow is the legal version of that. A third party temporarily holds onto a large sum of money and releases it when a particular condition has been met.
As you learn about buying a home, 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 Are Mortgage Escrow Accounts?
OK, so what the heck are these accounts for exactly?
What is a mortgage escrow account?
A mortgage escrow account works like a savings account, except it’s managed by a middleman rather than a bank.
What is a mortgage escrow account used for?
The escrow uses the account to collect and manage the funds needed to meet specific obligations throughout the life of your mortgage. An escrow account helps with:
- Covering estimated property taxes
- Insurance premiums
- Protecting your good-faith deposit and ensuring the money goes to the right person
Escrow accounts don’t help with:
- Utility bills
- Homeowners association fees
- Supplemental tax bills
Who manages a mortgage escrow account?
Escrow accounts are handled by a third party, which can include an escrow company, escrow agent or mortgage servicer.
What is an escrow balance?
This is the amount of money the lender deposits into your escrow account to pay for taxes, insurance and deposits.
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 (also known as earnest money). This deposit is placed into your account to show that you have the intention of completing the deal, and it usually equals 1% to 2% of the home price.
Why is earnest money held in escrow?
Earnest money shows the seller that you’re serious about purchasing the home. So once the good-faith deposit is in your account, the seller cannot accept additional 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
In many scenarios, a buyer can get their money back from escrow if:
- Financing falls through
- Undisclosed problems are discovered during the home inspection or title search
- 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.
Monthly Payments With an Escrow Account
Once you start making your mortgage payments, the escrow account is used to hold the money you’ll need to pay your property taxes and homeowners insurance.
How much money goes into an escrow account?
What you pay to your escrow account depends on the cost of your property taxes and homeowners insurance. Since these are paid annually, you should aim to sock away a fraction of the total cost each month.
Say your property taxes are $5,000 a year and your homeowners insurance is $1,000. You’ll be paying $6,000 for the year. $6,000 divided by 12 months is $500, and that’s what you should aim to put into your escrow account each month.
Making monthly payments with an escrow account is helpful because you can make 12 smaller payments rather than a few large payments each year.
Maintaining a minimum balance on your escrow account
To ensure that you can cover your property taxes and insurance payments, you are required to maintain a minimum balance in your escrow account. However, according to federal regulations, your escrow account should only have enough money to cover:
- Annual insurance and property tax bills
- A cushion of two extra monthly payments
- An extra $50
Escrow adjustments and refunds
Let’s say your property taxes are re-assessed or your mortgage premiums are re-adjusted. If the amount you need to pay goes up, the mortgage lender may increase your escrow payments to ensure that you have enough in your account to cover your payments. If the amount you need to pay goes down, your payments may go down (and you may even get a refund!).
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.