What is Mortgage Escrow?
The Bottom Line
A mortgage escrow is an account set up by your lender to collect certain required homeownership expenses, such as property taxes and insurance premiums, to make sure they get paid and to simplify payment for the homeowner.
When buying a home, you typically have to pay property taxes and homeowners insurance along with your principal and interest payments each month.
A mortgage escrow account is a tool designed to simplify this process.
How Does Mortgage Escrow Work?
The primary objective of an escrow account is to ensure timely payment of critical expenses, such as property taxes and insurance premiums.
By collecting a portion of these costs monthly, your lender builds a reserve to cover property taxes, homeowners insurance, and other applicable expenses. This helps avoid large lump-sum payments that could strain your budget as a homeowner.
How Funds Are Collected
If you have an escrow account set up with your lender, it means that when you make your monthly mortgage payment, a portion goes toward the principal and interest on your loan, while another portion is allocated to the escrow account.
Over time, this account accrues enough funds to pay your property taxes and insurance premiums when they are due. Your lender handles the payments on your behalf, removing the burden of tracking due dates and managing hefty one-time payments.
Impact on Cash to Close
Setting up an escrow account often requires an initial deposit at closing to ensure the account has sufficient funds to cover upcoming payments.
This deposit can be one of the larger expenses in your closing costs, as lenders typically require a certain number of months to be set aside (based on the due dates of your taxes and insurance) and a cushion to cover any potential shortfall.
What Does Escrow Cover?
A mortgage escrow account typically covers the following expenses:
1. Property Taxes
A portion of your monthly payment is allocated to cover your property taxes, which are often due annually or semi-annually. Escrow ensures these payments are made on time, avoiding penalties or liens.
You’ll still likely receive a property tax bill from your county’s tax assessor. However, you usually don’t need to pay this, since the payment will be handled with funds from your escrow account. If, for some reason, you owe more than what is available in your escrow account, your lender will contact you to resolve the issue and your payments will be adjusted accordingly.
2. Homeowners Insurance
Escrow accounts are used to pay your homeowners insurance premiums, protecting your property against risks like fire, theft, and natural disasters.
3. Other Costs
Depending on your loan and location, your escrow account may also cover:
Mortgage Insurance (PMI): Required on conventional loans with less than 20% down payment, and required on most government loans. Check out our guide to private mortgage insurance to learn more.
Flood Insurance: Required if your home is in a flood zone.
Escrow vs. Impound Account
The terms escrow account and impound account are often used interchangeably. They are essentially the same thing, but the term used depends on the lender and your location.
Both serve the same purpose: collecting and managing funds for taxes and insurance. However, in some regions, “impound account” is the preferred term, while “escrow” is used more broadly in other contexts, such as during the home purchase process.
After you’ve closed on your home is when a mortgage escrow account, or impound account, comes into play.
Who Manages Your Escrow Account?
Escrow works by having a designated third party hold funds and distribute them to the appropriate party or parties when due.
1. Escrow Companies and Title Companies
During the homebuying process, escrow and title companies often manage the initial setup and funding of the escrow account, ensuring everything is in order for closing.
2. Mortgage Servicing Companies
Once your loan is closed, the ongoing management of your escrow account typically falls to your lender or mortgage servicing company. They handle the regular payments to your county or local property tax authority, and annual or bi-annual payments to your homeowners insurance company.
How is Mortgage Escrow Calculated?
The amount needed for your mortgage escrow account can fluctuate since property taxes and insurance premiums often vary from year to year. Your loan servicer calculates your escrow payments for the upcoming year based on the bills they covered in the previous year.
To maintain a sufficient balance, most lenders require a cushion of at least two months’ worth of payments to be held in your escrow account.
The amount you pay into escrow each month generally depends on:
Property taxes: Based on your home’s assessed value and local tax rates.
Home insurance premiums: Includes homeowners insurance and any additional policies like flood insurance.
Mortgage insurance premiums: Based on the type of loan program, the term and other factors.
Timing of Payments
The timing of property tax and insurance payments can affect the initial escrow deposit. For example, if taxes are due soon after closing, the lender may require a larger upfront deposit to ensure the account has enough funds for the initial payment plus ongoing payments.
Annual Escrow Analysis
Lenders conduct an annual escrow analysis to adjust your monthly payments as needed. If taxes or insurance costs increase, your payments will be adjusted accordingly. Conversely, if there’s a surplus, you may receive a refund.
Benefits of a Mortgage Escrow Account
The biggest advantage to having an escrow account is that it takes the responsibility out of your hands.
You won’t need to worry about setting aside money for property taxes each month, as your mortgage servicer handles that for you by collecting funds regularly. Likewise, there’s no risk of misplacing the bill or forgetting to pay your homeowners insurance—your servicer takes care of those payments on your behalf.
Homeowner Benefits
Simplifies homeownership by bundling tax and insurance payments with your mortgage.
Avoids the burden of large lump-sum payments for taxes and insurance.
Protects against missed payments, avoiding penalties and lapses in coverage.
Mortgage escrow accounts are important to your lender, as well. If your property taxes go unpaid, the tax authority could place a lien on your home, potentially leading to foreclosure—a scenario that could result in financial losses for your lender.
Lender Benefits
Reduces risk by ensuring taxes and insurance are paid on time, which protects your lender’s investment in the property.
If your homeowner's insurance coverage lapses, significant damage could lead to significant loss of the home’s value, as it would need to be repaired or rebuilt.
Drawbacks of a Mortgage Escrow Account
While there aren’t any significant disadvantages to having a mortgage escrow account, there are a few things to keep in mind.
Overpayment or Underpayment: Miscalculations or fluctuations in your tax bill or insurance premium can result in escrow shortages or surpluses, making your monthly payment go up or down every six to twelve months.
Less Control: Homeowners may feel limited by not managing tax and insurance payments directly.
Escrow Cushion Requirements: Lenders often require a cushion, which can tie up funds that could be used elsewhere.
Can You Opt Out of Escrow?
Lenders often require escrow accounts as a way to minimize their financial risk. While it’s possible to get a mortgage without an escrow account, eligibility depends on factors such as your loan type, down payment size, and credit history.
Certain loan programs, like FHA and USDA loans, mandate escrow accounts. The VA does not require escrow accounts, but many lenders impose their own requirements, meaning you’ll probably need an escrow account for most VA loans.
Escrow Waiver Fees
Some lenders may charge a fee for opting out of mortgage escrow, so it’s essential to weigh the costs and benefits carefully. If you qualify to opt-out, or “waive escrow,” this usually involves an upfront fee or a slight increase to your interest rate.
For conventional loans, most lenders charge an escrow waiver fee of .25% of the loan amount.
For example, if your loan amount is $300,000, you may need to pay a $750 fee ($300,000 x .25% = $750).
Escrow for Refinance and Home Equity Loans
Refinancing
When refinancing your mortgage, your escrow account may need to be adjusted or reestablished, especially if your taxes or insurance premiums have changed, or if there’s a shortage in your current escrow account.
Home Equity Loans
For home equity loans or HELOCs, escrow accounts may not always be required, as these loans typically do not affect your primary mortgage’s escrow setup.
What to Do If You Have Issues with Your Escrow Account
If you have questions about your escrow account or believe there’s an error, reach out to your mortgage lender for clarification.
Common Issues
Shortages: When the account doesn’t have enough funds to cover payments.
Overpayments: Leads to a surplus, which may be refunded or applied to future payments.
Discrepancies: Errors in tax or insurance calculations.
Steps to Resolve Issues
Request an escrow analysis from your lender.
Review your annual escrow statement for accuracy.
Set up an alternative payment plan if necessary.
The Bottom Line on Mortgage Escrow Accounts
Whether you’re a first-time homebuyer or an experienced homeowner, mortgage escrow can be a valuable tool for navigating the complexities of homeownership and long-term financial planning.
If you’re considering a home loan or have questions about escrow, contact your lender to learn more and ensure your account is being managed effectively.
