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.

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.

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.

Funds in an escrow account can be used for different purposes, but most people encounter them related to real estate. A mortgage lender collects these 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 escrow works

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.

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.

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 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 accounts for homebuying: This type of mortgage escrow account happens before buying a home. It’s usually somewhere between 1% and 2% of the home’s final purchasing price. This is also called earnest money and indicates to the seller that you’re serious. It will not be cashed 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.

Escrow FAQ

Bottom line: What does escrow mean?

Escrow means a few different things, depending on where you’re at in the homebuying process. If you’re still in the purchasing phase, escrow refers to the time between writing up a contract and closing on the house. After you purchase the home, escrow refers to prepayment for taxes and insurance. Your lender collects escrow each month and saves it in an account for use at the end of the year when your insurance and taxes are due.