What is escrow?

Most people need escrow accounts when they get a mortgage for taxes and insurance reasons. In this resource, we explain what escrow means, the different types of escrow accounts and how it all works.

Escrow describes a situation in which a neutral third party holds funds or an asset until a condition is met.”

What is an escrow account and how does it work?

Escrow accounts, sometimes called trust accounts or impound accounts, are a type of prepayment account. Escrow is most commonly used to hold funds intended to pay taxes, insurance premiums and related expenses.

Escrow accounts can be used for different purposes, but most people encounter them in the real estate context when a mortgage lender collects funds with your monthly house payment and puts them into an escrow account.

It may seem confusing, but escrow accounts are fairly straightforward and can save everyone a headache in the long run.

How does escrow work?

With each mortgage payment, a portion of the payment is deposited into an escrow account.

To be “in escrow” means that some amount of money or piece of property is temporarily controlled by a third party until a specified condition has been fulfilled, such as the closing of a deed. An escrow advance is any amount of funds put toward taxes or insurance premiums. An escrow disbursement is when the funds are used to pay for charges and expenses out of the account.

An escrow account works sort of like a savings account, but it’s managed by your mortgage servicer and doesn’t earn interest. You can think of an escrow account as a prepayment account used to cover the costs of homeowners insurance, taxes and other fees.

When you make an offer on a house, you pay earnest money into an escrow account. This functions as a sort of promise to the seller. The earnest money is put into an escrow account and later added toward your down payment.

After closing, an escrow officer estimates how much you will owe at the end of the year in homeowners insurance and taxes. This estimated escrow amount is then divided by 12 and added to your monthly mortgage payment each month. Lenders sometimes require a “cushion,” which is an additional amount due with your monthly escrow payment, to cover their expenses.

Each time you make a mortgage payment, your servicer deposits a portion of the payment into an escrow account. The funds in the account cover your real estate taxes and insurance premiums when they are due.

Your lender takes that escrow advance, sets it aside and saves it for the end-of-year payment. An escrow agent then performs an escrow disbursement, meaning they take the money you have saved and put it toward the total expenses.

If you owe more than you have saved, you must pay the difference. If you put more in escrow than you end up needing, you get a refund.

Types of escrow accounts

Depending on where you are in the homebuying process, there are two main types of escrow accounts: one before and one after the purchase. Most lenders require both types of escrow.

• Escrow for earnest money: This type of escrow account is for earnest money, which indicates to the seller that you’re serious about your offer. The amount is usually somewhere between 1% and 3% of the home’s final purchasing price. It is in escrow until after purchase. After the sale is complete, this money is put toward the down payment. If the homebuying process falls through, this money might not be returned.
• Escrow accounts for taxes and insurance: After purchase, you will usually see a line on your monthly mortgage statement titled “escrow.” This number is a portion of your annual estimated insurance and tax expenses. Your escrow taxes and insurance amount can change from year to year. Your lender will estimate it based on the previous year plus two extra months, meaning you might receive a refund at the end of the year. This will be reflected in your monthly mortgage statement.

Benefits of escrow

Escrow is meant to help homeowners avoid writing a large check at the end of the year and help show sellers that a buyer is serious about the transaction. Escrow has many benefits in homebuying, both for the buyer and the seller.

• Protection for the buyer:  Escrow safeguards the buyer’s down payment until the sale goes through. The buyer is protected from losing the money in case of agreed-upon contingencies. Escrow also helps homeowners set aside money for taxes and insurance.
• Protection for the seller: Putting earnest money in escrow demonstrates the buyer’s commitment to purchasing the house and not abandoning the deal.
• Protection for the lender: By putting part of the monthly mortgage payment in escrow, the lender knows the funds are available for paying insurance premiums and taxes on the property.

Bottom line: What does escrow mean?

Escrow refers to a process where a third party holds onto a large amount of money or property until the parties involved in a transaction meet certain conditions. Depending on where you are in the homebuying process, you may be using an escrow account to hold earnest money, or your lender may be setting aside part of your monthly mortgage payment in an escrow account to pay for insurance and taxes. Escrow is a common part of the homeownership experience and protects buyers, sellers and lenders.