What Is an Escrow Account and How Does It Work?
An escrow account is a form of savings account routinely used both during and after the real estate purchase process. Consumers don’t typically shop for their own escrow account. Instead, escrow accounts are established by a lender. They’re used as deposit accounts for earnest money when you purchase a home, and in most cases, an escrow account is required by your mortgage lender as a holding account for home expenses such as property taxes and insurance. Recent CoreLogic research indicates that 80% of U.S. mortgage borrowers use loans featuring escrow accounts. According to CoreLogic, lenders and loan servicers prefer to see escrow accounts established because they provide assurance that funds for the variable “taxes and insurance” portion of “principal, interest, taxes and insurance,” or PITI, are set aside.
Escrow accounts typically begin the moment you close on the house. When you buy a home, you’ll likely see references to “recurring” closing costs and “non-recurring” closing costs. Non-recurring costs are what you typically think of as closing costs — like origination fees, discount points, and appraisal, title and recording fees. You only pay these once as part of the loan approval process.
Recurring costs are tied to the ownership of real estate. The most common recurring closing costs are property taxes and homeowners insurance. The amount of property taxes you pay depends on county and city you live in. Homeowners insurance is required to protect the lender against any losses from fires, vandalism and theft.
It’s these recurring costs that calls for an escrow account. Your lender will generally set up a non-interest bearing savings when you buy a house to pay the property taxes and insurance when they come due. Each month, part of your total mortgage payment will go into this account.
If you decide that you no longer want an escrow account, or you sell your house, the balance in the account is refunded to you.
Some homeowners with mortgages may have trouble fully understanding escrow and why it matters. With an escrow account, a portion of your monthly payment goes into a separate account to cover certain non-mortgage expenses.
To get a handle on how to put money in escrow, it’s important to remember that the funds in your escrow account don’t pay down the principal or interest on your mortgage.
What are the basics of an escrow account?
An escrow account is managed by your mortgage lender. It is typically set up when your loan is originated. From that point forward, the account is maintained with a portion of each of your monthly mortgage payments going toward property taxes, homeowners insurance and mortgage insurance (if applicable).
Your lender uses the money held in the account to pay insurance and property taxes on your behalf. This way, there’s no need to worry about coming up with a lump sum to cover those expenses by their due dates.
When you make an offer on a home, your earnest money for the purchase goes into an escrow account for future disbursement to the seller (assuming the transaction proceeds). This type of escrow account is short-lived and transaction-related.
When you purchase a home backed by the Federal Housing Administration (FHA), a portion of the funds you borrowed will automatically be set aside by your loan servicer in an escrow account from which your lender will pay your insurance and property taxes. Lenders underwriting non-FHA loans may choose whether to require escrow accounts for borrowers based on a variety of factors including down payment size and credit score. Lenders must disclose in a “good faith estimate” document provided to borrowers whether the loan they’re offering includes or excludes an escrow account and what portion of funds involved in the initial home transaction will initially fund the account.
Escrow covers the aspects of a housing payment beyond mortgage principal and interest that concern lenders — taxes and insurance. Taxes may include city, county or other special local taxes. Insurance can include property insurance, hazard insurance, supplemental insurance (earthquake, flood zone, etc.) and mortgage insurance.
Escrow doesn’t cover utility payments or payments related to home repair, maintenance or improvement. When you close on the purchase of your home, you will receive an escrow statement as part of your closing documents. The Consumer Finance Protection Bureau (CFPB) provides this example 1.
The advantages of not having an escrow account
Depending on how sophisticated your financial planning is, there are advantages to not having an escrow account on real estate you own.
You can invest the money you save elsewhere
Property tax rates vary based on where you live. If you live in Alabama, and are buying a house in Baldwin County, you’ll pay about $444.85 a year in property taxes for a $143,500 house (the median price for that state). If you are buying a house in the San Francisco Bay Area, where the median price is $1.6 million, your yearly property taxes will be $8,800.
It might not make sense to forego the convenience of an escrow account to invest $444.85 each year somewhere else if you are buying a house, for example, in Baldwin County, where prices and taxes are relatively low. However, on the larger tax bill for a home in say, San Francisco, you might be able to generate enough return to make it worth your while to invest.
You have a lower monthly payment
Instead of having a higher monthly bill that includes your escrow payments, you’ll just pay the entire property tax and insurance bills when they come due. You won’t have to worry about notices from the your lender and track whether the taxes have gone up or down.
You avoid increases in your monthly housing expense
If you have a fixed-rate mortgage with an escrow account, the only thing that could cause a rise in your monthly payment is that escrow account. Higher property taxes or an increase in your homeowner’s insurance premium raises the amount you pay each month. If you have a comfortable cushion of cash reserves to pay for the property taxes and insurance when they come due, there’s really no need to have an escrow account set up.
You also won’t have to wait for your yearly notice from your lender to find out your homeowner’s insurance premium went up — then negotiating for a better rate switching companies, and having to deal with your lender to make all the changes. You can just cancel your old insurance and pay for a new policy without any third party being involved.
Disadvantages Of Not Buying With An Escrow Account
If you make the decision to cover the cost of your property taxes and insurance without the help of your lender, here are a few tips.
Be prepared to negotiate the fee for an escrow waiver: Lenders like the security of knowing your property taxes and insurance are paid with an escrow account. In fact, they consider loans without escrow accounts to be a higher risk of default. borrowers who didn’t have escrow accounts during the housing crisis were more likely to get behind on their mortgage payments than those who had them.
That’s why lenders generally charge fees to waive escrow accounts. The fee for an escrow waiver will vary by lender, but in most cases comes out to about 0.25% of your loan amount. On a $200,000 loan, that means you’ll spend an extra $500 upfront if you choose not to have an escrow account.
Lenders will contact you if your property taxes are unpaid: Lenders have systems in place to track the payment of your property taxes and if you get behind, you may get a notice from them checking into make sure everything is OK. If you fall on hard times, you may be able to contact the lender to set up some type of an account to have them help budget for the payment of the taxes.
You may be forced to pay for homeowners insurance that your lender chooses: When you get a mortgage, your lender will be added to your homeowners insurance so they can be paid in the event that there is an insurable loss on your home.
If there is a lapse in payment, they have the right to force you to take insurance that they choose, usually at a much higher expense. If you change homeowners insurance companies, be sure to notify your lender so you don’t get an unpleasant letter about having an uninsured home.
Determining escrow payments
Escrow payments are estimated annually by your lender. Using annually established property taxes and applicable insurance premiums, lenders will take the yearly total of these figures and divide it by 12, then wrap the result into your single monthly housing payment. When you pay your mortgage, the portion for insurance and taxes will go into your escrow account and the lender will use escrowed funds to pay those bills on time.
Lenders must conduct what’s known as a yearly escrow analysis in order to make sure you’re paying enough into the account for the lender to disburse adequately to taxing authorities and insurers. The amount of funds required in your escrow account can shift from one year to the next. This is because insurance rates for an existing policy can rise, or you may choose to pay more for increased coverage, and real estate taxes typically rise slightly over time due to local levies or shifting property values.
Freddie Mac reminds borrowers that escrow accounts use estimates to project the coming year’s expenses, which means escrow accounts may need adjusting after a lender’s analysis. If your account shows a shortage or deficiency, a lender may choose to do nothing about it, provide you with 30 days to pay the shortage amount, or let you spread payments over the coming 12 months in the form of a small increase to your mortgage payment.
If a shortage exceeds the average monthly payment, the lender must let you spread payments over 12 months rather than force you to make the entire payment immediately. If an escrow account shows an overage of $50 or more, your lender must send you a check for the amount within 30 days of the escrow analysis, otherwise, the lender can apply the excess funding toward the coming year’s expenses.
If your lender or servicer sets up an escrow account at closing, you won’t need to do any of the math yourself to calculate your monthly escrow payments. Your lender or servicer will determine how much needs to be paid into your escrow account each month, and it will adjust your mortgage payments accordingly.
Determining your monthly escrow account obligation is a fairly simple task for your servicer. Once your mortgage is closed and your escrow account is set up, the deposit amount needed is determined using three factors:
- Property taxes
- Insurance premiums
- Escrow account minimum balance
Your servicer will start by estimating the amount you’ll owe for property taxes, homeowners insurance, mortgage insurance and any other type of coverage, such as flood insurance, over the next 12 months. These numbers can come from tax records, your insurance company and your mortgage closing documents.
Your tax and insurance bills are then divided by 12 and added to your monthly principal and interest payments to come up with a comprehensive monthly mortgage payment. This is where the PITI acronym comes from — principal, interest, taxes and insurance.
There’s a required minimum balance that should sit in your escrow account at all times. This is because property taxes, insurance premiums and other expenses paid through your escrow account can — and do — fluctuate each year. By keeping a minimum balance — up to two months of escrow payments — in your account, you can minimize any impact that arises from potential increases.
It’s difficult to predict how much your escrow account can change each year. While the principal and interest portion of your mortgage payment stays on a predictable path, it’s hard to know how much your property taxes or homeowners insurance might cost from one year to the next. As a result, your escrow payments need to be tweaked over time to account for adjustments.
How much can my lender keep in escrow?
Under the Real Estate Settlement Procedures Act (RESPA) 3, loans that require escrow accounts will calculate escrow as part of closing documents. Borrowers whose lender requires escrow will pay a flat fee to their mortgage lender each month, a portion of which will go toward funding the borrower’s escrow account. Their mortgage bill will explain what portion of their payment covers principal, interest and escrow for taxes and insurance. From there, the lender is responsible for paying the borrower’s insurance and taxes out of escrow.
Loans that don’t require escrow accounts as a condition of closing, where the borrower will establish their own escrow account, require the loan servicer to provide the borrower with a statement of escrowed expenses within 45 calendar days of closing. Generally, these expenses include insurance and taxes.
A loan servicer may ask a borrower to pay 1/12 of the total annual escrow payments it estimates it will pay out of the account. Additionally, a loan servicer may require payments from the borrower so that the account has a cushion. A cushion allows the lender to have coverage for payments that are not monthly but, perhaps, quarterly or semiannual.
Lenders may keep no more than 1/6 of the total annual cost of escrow-paid items in an escrow account. For example, if a home’s property taxes are $4,000 per year and its insurance is $800, then the annual amount in escrow should be $4,800. This means that an escrow account can’t keep more than an $800 (1/6 of $4,800) as a “cushion” in the account. A cushion is not counted as an overage.
The amount you’re required to keep in escrow can vary by lender. However, certain guidelines are in place by the Real Estate Settlement Procedures Act (RESPA) to oversee this process. This act places strict controls over how much money your lender can require for your escrow account, along with how it is paid out.
Through RESPA, your lender can only require you to pay up to 1/12 of the total needed per month for all annual escrow items during the year. The lender may also require a cushion that can’t exceed an amount equal to 1/6 — or two months — of escrow payments for the year.
RESPA also enforces the previously mentioned rule that if an escrow account has a surplus of $50 or more, it must be returned to the borrower within 30 days of the yearly escrow analysis being completed.
Do you have enough in your escrow account?
As a borrower, there’s a straightforward way to determine if your escrow amount is being held to RESPA standards. By adding up the totals for your annual property taxes, homeowners insurance, mortgage insurance and other housing-related bills paid through escrow, you can make a quick calculation on your own. Here’s an example:
Let’s say you owe $2,400 in property taxes annually, along with $1,200 in annual homeowners insurance premiums. Additionally, because you put less than 20% down when you bought your home and have a conventional mortgage, you also pay $100 a month in private mortgage insurance.
|Escrow Item||Annual Amount|
|Private mortgage insurance||$1,200|
In total, you may be asked to pay $4,800 in escrow expenses annually, plus keep a buffer in your account of two months’ worth of expenses. To calculate two months of escrow expenses, first divide $4,800 by 12 to get $400, which is one month of escrow expenses. Two months equals $800.
So during that year, you may be asked to pay $4,800 plus an $800 buffer, for a total of $5,600.
As a result, your monthly escrow payment would be around $467 ($5,600 divided by 12), although the total payment depends on how much your mortgage servicer asks you to keep as a buffer and whether that amount was funded at your mortgage closing ahead of time.
When an escrow account is required?
The only loan programs that require an escrow account are the USDA and the FHA loan programs. Conventional and VA loans don’t mandate escrow accounts, but most lenders will advise you to have one if you are making less than a 20% down payment.
But if they’re not strictly required, why do the majority of homeowners have escrow accounts?
The answer: Lenders want to protect their interest in your home. If you’re delinquent on property taxes, the government can foreclose on your house even if your mortgage payment is current. Adding risk to the lender, these unpaid property taxes can take priority over a mortgage loan if you default. The state you live in may even have the right to take ownership of the home without the loan being paid off.
Lenders also want to track the payment of your homeowners insurance to make sure that the value of the home can be restored in the event of a hazardous event like a fire or vandalism. When you were approved for your mortgage loan, the lender appraised your home based on the condition it was in when you bought it. By paying your homeowners insurance every year when it comes due, you — and the lender — will be covered if something catastrophic happens to your home.
Can you avoid an escrow account?
FHA borrowers, who constitute a large percentage of first-time buyers, cannot avoid escrow accounts. Borrowers using other loan types may pursue an escrow waiver. Typically, to secure an escrow waiver, you must use a loan with at least a 20% down payment (known as 80% loan-to-value, or LTV) and you may also need to pay points fees on your loan. Some lenders in 2018 began experimenting with waiving escrow on loans with down payments as low as 5%. Points for escrow origination generally cost $250 per $100,000 borrowed.
Fannie Mae states that it discourages lenders from using LTV alone as the basis for waiving escrow. The government-backed agency also states that any lender permitting waivers must have a stated policy detailing what circumstances must be satisfied for a waiver to be granted.
Because an escrow waiver will require that you as borrower keep track of making timely and often large lump-sum payments for property taxes and insurance, proof of financial responsibility in some form — a high credit score, strong cash reserves — may also contribute to a lender’s decision to grant or deny an escrow waiver.
Escrow accounts let homeowners spread routine yet important housing costs across the monthly payments they make throughout the year, and they make the lender responsible for timely payments to taxing and insurance authorities (and for any fees should the lender make mistakes).
The financial savings possible from forgoing an escrow account and managing tax and insurance bills yourself is negligible, but avoiding escrow may nonetheless appeal to some buyers who have the resources and organizational skills to manage these bills on time, themselves.
When an escrow account is optional?
With a down payment of more than 20%, in most cases an escrow account is optional. The FHA and USDA programs are the exception, but most borrowers who can afford a 20% down payment likely wouldn’t apply for a FHA or USDA loan.
Here are some other scenarios where an escrow account is optional.
If you are buying investment property: If you want to control your net cash flow on your investment — the difference between your rent and the mortgage payment — you may not want to have an escrow account.
If you are taking out a reverse mortgage: Reverse mortgages are only for homeowners over the age of 62, and they do not require an escrow account. The program is designed to give you access to your equity without any monthly payment, so you won’t get a monthly mortgage statement. You can request something called a “set-aside” from your reverse mortgage lender if you are concerned about the property taxes or insurance being paid.
If you are refinancing and have 20% or more equity: If you are refinancing a conventional or VA loan and the amount of your loan is 80% or less of the value of your home, in most cases you can choose not to have an escrow account.
Do I Need An Escrow Account?
Roughly four out of five homeowners have an escrow account as part of their mortgage.
These accounts are part of your monthly payment, but go toward things like property tax and insurance instead of principal and interest. It makes sense: Having your lender make these payments so you don’t have to worry about them allows you to focus on other aspects of homeownership. Plus, lenders prefer the security and guarantee that these things will be paid.
However, escrow accounts are not required on all mortgage loans. Despite the convenience, some borrowers don’t like the idea of having thousands of dollars sitting in a non-interest-bearing account. They don’t want to pay extra money into that account just so their mortgage company can write the check for two housing-related expenses they’ve already agreed to pay.
Can I opt out of an escrow account?
Some mortgage lenders require escrow accounts, such as those who originate loans backed by the Federal Housing Administration (FHA) and U.S. Department of Agriculture (USDA). Conventional lenders and those who originate loans backed by the Department of Veterans Affairs (VA) don’t require escrow accounts, but they advise them for borrowers making less than a 20% down payment because there’s more risk involved and they want to protect their interest in the home.
If you put down 20% or more, you may be given the option to have an escrow account or save the money separately and pay these expenses yourself. If you want your lender to consider granting you an escrow waiver, you’ll not only need a larger down payment, but you must show your ability to handle lump-sum payments of your insurance and taxes. There may also be a waiver fee involved, which might cost 0.25% of your loan amount, though it’s best to double-check with your lender. While there are pros and cons to either scenario, an escrow account can make keeping up with — and planning for — these housing-related bills much easier.
At the end of the day, whether you can avoid keeping and paying into an escrow account is up to your lender’s discretion. The lender wants assurance that your taxes and insurance bills are covered because missed payments can lead to a lapse in homeowners insurance coverage when it’s most needed or a property tax lien that would take priority over late mortgage payments if you default.
If and when your mortgage is paid in full, you won’t need an escrow account. Once you own your home outright, you’ll still be required to pay property taxes and any other housing-related bills on your own and without prompting from a third party.
Can you cancel an escrow account?
Once you’ve been diligently paying down your mortgage on time and build 20% equity, your lender may give you the option to cancel your escrow account. Requirements to drop escrow payments might also include not having a tax or insurance bill due within 30 days of the cancellation request.
Quicken Loans requires borrowers to meet the following requirements to cancel their escrow account:
- Have equity: You need 20% for a conventional loan and 10% for a VA loan.
- Have a good credit score: You need a 680 for a conventional loan and 720 for a VA loan.
- Have at least a 1-year-old mortgage: Loans backed by Freddie Mac or the VA must be a year old, while Fannie Mae loans must be 2 years old.
- Have a positive escrow account balance.
- Be current on mortgage payments: You can’t have any 30-day late payments in the past year. Also, you can’t have any 60-day late payments in the past two years for Fannie Mae loans.
If you’re able to opt out of an escrow account but don’t keep up with your bills, your lender might set up a new escrow account against your will. It can also add the costs of unpaid bills to your loan balance and even purchase homeowners insurance for your property and bill you for it. This insurance, forced-place insurance, is typically more expensive than a homeowners policy you could buy on your own.
What is a yearly escrow analysis?
Escrow accounts are typically analyzed yearly to verify there’s enough money in them to cover upcoming bills for insurance and taxes. The annual escrow analysis includes information about the insurance and tax bills paid over the past 12 months with available escrow account funds. It also provides you with a rundown of how much those bills are expected to cost over the next year and how your monthly mortgage payment is expected to change — if at all.
You may expect to find the following information in your yearly escrow analysis:
- Current monthly mortgage payment
- New monthly mortgage payment
- Escrow account summary
- Escrow account history
- Escrow shortage coupon or surplus check (more on this below)
- Expected escrow activity over the next 12 months
- Expected escrow payments over the next 12 months
What about an escrow account surplus or shortage?
Your annual escrow analysis will also include information on whether there’s a shortage or surplus in your escrow account.
If your account is falling short — maybe rising property taxes or insurance left your escrow account in the red — your servicer could give you a shortage coupon, which you can cut out and send with a payment equal to the shortage amount. Depending on your lender or servicer, you may also be able to pay the shortage amount online. Generally speaking, you can make a full or partial payment to cover the escrow shortage or spread it out and pay it back in addition to your mortgage payment each month over the next 12 months.
If you have an account surplus, you may receive an escrow surplus check. Lenders are required to return any surpluses $50 or more. This is your money that was overpaid, so you can cash the check.
Escrow expenses are always there — so shop around
When you are shopping for mortgage companies to determine who has your best rates and fees, you may overlook the expenses related to the ongoing costs of the home you are buying. The same is true when you are refinancing.
If property taxes are due in your county around the time your first mortgage payment is due, you may need to pay the entire amount due at closing. The same is true of your homeowners insurance premium: If it’s due within a month or two of when you’ll be making your first mortgage payment on a purchase or a new refinance loan, you may end up paying the entire premium due at your closing.
If you have a complex financial plan, or own a home or real estate in a place where prices and tax rates are higher, it’s worth it to have your financial planner crunch some numbers for you to determine if your money is better invested in the market than in a non-interest-bearing real estate escrow account.
If you choose not to escrow, be sure to have a system for paying your property taxes and insurance, so your mortgage lender doesn’t end up coming up with one for you. You may not need an escrow account to keep track of your housing expenses, but you absolutely need to make sure those housing expenses are paid on time to avoid any problems with your mortgage lender.
Although the costs of escrow items increase your monthly mortgage payment, having an escrow account in place reduces the burden of scraping up lump sums for your taxes and insurance when they come due each year.
Even if you can and want to opt out of an escrow account, it may be safest to have one anyway so that your annual obligations are handled without interruption.
While paying money into an escrow account may feel like you’re just throwing it away, it’s important to remember that the money is still yours. You’re required to pay your property taxes, homeowners insurance and other bills regardless, but an escrow account makes the process easier.