The word “escrow” comes up a lot during the homebuying process. If you’re a first-time homebuyer, you may be wondering, What is escrow on a mortgage? What are escrow payments?
“Escrow is the practice of handing money over to a third party while in the process of finalizing a major financial transaction, like a real estate purchase,” says Martin Orefice, CEO of Rent To Own Labs, a real estate platform based in Orlando, Florida.
Escrow accounts are used in two ways that affect homeowners: to oversee the homebuying transaction, and to ensure ongoing essential fees such as property taxes and homeowners insurance are paid in full and on time.
- Escrow refers to third-party accounts used to collect and pay out money in a major financial transaction.
- Escrow accounts are used to guarantee an orderly and accurate transaction when a property is sold, and to collect funds to pay homeowners insurance premiums and property taxes.
- While an escrow account for insurance and taxes increases the monthly payment, it simplifies the process of paying those large, essential bills.
What Is Escrow?
You can think of escrow as an independent account managed by a third party. It’s used to collect, hold, and pay out funds in a major financial transaction. It also handles some documents that are essential to the sale.
All the money that changes hands in a home sale — including the down payment, the loan principal, and the closing costs — is paid into an escrow account. The third party managing the account then disburses all the funds to the appropriate parties. This ensures a fair, legal, and accurate transaction that makes sure every last cent is paid the right party, and is fully accounted for.
How Escrow Works for Buying or Selling a Home
Buyers pay an initial deposit to start the escrow process. You can find this amount listed in Section G on Page 2 of the loan estimate that your mortgage lender must provide to you within three business days of receiving your application. Be sure to confirm that amount when you get your closing disclosure, as it can change in the interim.
You and your lender will deposit the down payment, the mortgage principal, the closing costs, and any other funds required for the sale into the escrow account.
As key conditions of the sale are met, the escrow manager will disburse money from the escrow fund to pay fees, closing costs, and the seller’s lienholder. Once everything’s paid, the remaining cash goes to the seller.
If funds need to remain in escrow past the finalization of the sale, it’s called an escrow holdback. This can occur when the home needs repairs, or the seller has to stay in it longer than expected.
How much are escrow fees on a mortgage?
Escrow fees usually cost 1% to 2% of the home‘s purchase price.
Homebuying fees held in escrow
Fees that are commonly held in escrow during a home purchase include:
- Mortgage origination fees.
- Property taxes and other applicable county fees.
- Commissions or fees charged by a real estate attorney.
- The seller’s profit from the sale.
- Homeowners insurance premiums.
- Other third-party payments like title insurance fees.
Who pays for an escrow account?
Escrow fees typically are split between the buyer and seller, though they can be divided up any way the parties choose. For example, the buyer may volunteer to pay all escrow costs to help convince the seller to accept their offer on a house. In any case, both the buyer and seller should agree upon who is responsible for the fees beforehand, and include that information in the purchase and sale agreement.
Who manages escrow on a mortgage?
Escrow accounts may be managed by an escrow company, a title company, a law firm, or your mortgage servicer. The escrow manager’s job is to ensure the transaction is handled in a timely, fair, and accurate manner.
How Escrow Works for Paying Property Taxes and Insurance Premiums
You may use an escrow account to pay expenses such as property taxes and homeowners insurance premiums after the sale closes. This also is known as an impound account, and is created and managed by your lender when you get your mortgage.
Lenders usually require a minimum amount held in the account when a new mortgage is taken out. In most cases, you’ll need to put at least two months’ worth of escrow payments into your account at closing.
Escrow accounts help ensure tax and insurance bills are paid on time and in full. There are cases where borrowers may forget to save up enough to pay these bills, incurring a tax lien on the home or lacking insurance when disaster strikes.
Many lenders require escrow accounts. The type of mortgage you have also will determine whether an escrow account is required. For example, if you have a loan backed by the Federal Housing Administration, you must have an escrow account.
Homeowners who opt out of escrow accounts are responsible for paying their property taxes and homeowners insurance premiums directly. There can be serious consequences for failing to pay property taxes, including fines, penalties, tax liens, or even foreclosure. If you don’t pay for homeowners insurance, your lender may buy a policy on your behalf and bill you for it.
How are my escrow bills calculated?
Your escrow bills are calculated based on property tax records for the property, and market rates for homeowners insurance premiums.
Your lender will estimate the annual cost of your home’s property taxes and homeowners insurance policy. You’ll receive a summary of this estimate, which is called an escrow analysis.
The estimated annual amount typically is prorated; your lender divides the total by 12, and then adds that amount to your monthly mortgage payment. This portion of your payment is held in an escrow account managed by your lender, which will use those funds to pay your property taxes and homeowners insurance premiums on your behalf.
What if I pay too much or too little into escrow?
Remember, the lender is estimating these costs. If the estimate comes up short, your lender will require you to pay the difference between the escrow balance and the actual bill. This may be paid as a lump sum, or prorated and added to next year’s escrow payments. If there’s money left over in escrow after paying those bills, your lender typically will refund you the difference.
What bills can be paid with escrow?
Bills you can pay with escrow include local and state property taxes, and homeowners insurance premiums.
What bills cannot be paid with escrow?
Bills that typically cannot be paid via escrow include homeowners association dues, flood and earthquake insurance, utility bills, and any supplemental taxes.
Pros and Cons of Escrow Accounts
There are some pros and cons to using an escrow account:
Advantages and Disadvantages of Escrow Accounts
| Benefits | Drawbacks |
| The buyer’s and seller’s interests and funds are protected during a home sale. | Your monthly mortgage payment is higher. |
| You can pay your property tax and insurance bills as you go instead of facing a large bill every six or 12 months. | You can’t access or otherwise use the cash in an escrow account. |
| Your lender or escrow company will cover shortages temporarily if there isn’t enough in your escrow account to cover the full bill. | You may have anunexpected bill to pay if your escrow balance falls short of your actual bills. |
| Your lender handles paying your insurance and tax bills on time for you. | You likely need to make two months’ worth of payments upfront when you close on the home. |
FAQ: Escrow Account Basics
Here are answers to common questions about escrow accounts in real estate.
Maybe. Lenders generally let you remove an escrow account if your loan is in good standing and your home equity is at least 20% of the property’s market value. However, requirements vary by lender and by state.
You’ll need to make a written request to your lender to file what’s often called an escrow waiver. Your lender can explain its specific requirements for cancellation.
Yes. Be sure to share as soon as possible the new policy information with your escrow manager, so they’re in the loop and paying the right provider.
You may access the money in your escrow account, but there are trade-offs involved.
“Taking your money out of an escrow account before completing the transaction will effectively mean canceling the transaction, and may result in penalties or fees,” Orefice says.
If there’s money left over in your escrow account after your insurance and tax bills have been paid, your escrow manager will refund you the difference. This is called an escrow refund. You also may be able to get an escrow refund if you pay off your mortgage completely or get a better rate on your homeowners insurance with a different provider.
The Bottom Line on Escrow Accounts
If you’re buying a house, escrow is an important part of the process. During the sale of a home, an escrow account ensures an accurate, legal, and orderly transaction. After you close on a home, an escrow account offers an easy way to pay essentials such as your homeowners insurance premiums and property taxes on a monthly basis. In both cases, escrow is a way homebuyers can have confidence that their most significant financial transactions will go smoothly.
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- What Is Earnest Money and How Much Should You Pay?
- Frequently Asked Questions About Mortgages — Answered
- ‘Hidden’ Costs of Buying a Home
- What Is a No-Closing-Cost Mortgage? How To Get One
- Proof of Funds in Real Estate: What Is a POF Letter?
- What Is a Title Search?
- How Long Does It Take To Close On a House?
Sarah Li-Cain contributed to the reporting of this article.
