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.
- How much are escrow fees?
- Escrow fees vary greatly, depending on where you live and your home’s purchase price. Most of the time, the escrow officer calculates buyers’ and sellers’ fees separately. Escrow costs are usually included at closing and go toward the total closing cost amount (typically between 2% and 5% of the purchase price). If you break it out, the initial escrow payment required at closing is around 1%.
For example, let’s say your home’s purchase price is $300,000. There might be a base fee of $500 plus a $2 fee per $1,000, which equals $1,100. The buyer and the seller would both be charged this fee, which equals $2,200.
- What is escrow balance?
- Escrow balance is the amount you have in your escrow account at any given time. Your escrow balance is managed by a neutral third party and put toward homeowners insurance premiums and property taxes on your behalf.
- Can I pay my escrow in advance?
- Yes, you can pay escrow in advance. However, be aware that making extra escrow payments will not go toward paying down your principal balance. It’s smart to contact your mortgage lender if you have any questions about making more payments toward your escrow balance.
- What is an escrow refund?
- An escrow refund is much like it sounds — it means you put more into the account than you needed, and a portion is returned back to you. Remember that your escrow officer or agent estimates your payments, so they are not set in stone. If you pay more than you need, your escrow agent refunds you the difference.
- Do escrow accounts earn interest?
- No, escrow accounts typically do not earn interest.
- How long does it take to close escrow?
- In most cases, you’ll close escrow on the same day you finalize and close on the home purchase. Thus, it might take up to 45 days, in theory, to close escrow.
- What are escrow services?
- Escrow services provide a secure and safe way to complete large financial transactions. Escrow companies and escrow officers are neutral third parties that hold money or property on behalf of the buyer and the seller. The escrow company makes the transaction safer and smoother.
- What is earnest money?
- When you make an offer on a house, you write an earnest money check. Earnest money functions as a promise to the seller that you intend to follow through with the purchase. The funds are put into an escrow account and transferred to the seller when closing is complete.
- Do you need an escrow account?
- Although no federal law mandates that you open an escrow account, most conventional mortgage lenders do require you to open an escrow account as part of the homebuying process.
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