If you own a home and are making monthly payments, you have probably read over the breakdown of your monthly mortgage charges once or twice. Your mortgage payment likely breaks out your monthly payment into three parts: principal, interest and funds that go to your escrow account.
While you likely know that the principal is how much of your monthly payment goes to pay off the amount you borrow and the interest is what you’re paying the lender for letting you use its money to buy your house. What you may not be as familiar with is what escrow is. So what does escrow pay for?
The escrow account associated with your mortgage is where the money for your taxes and homeowners insurance premiums are deposited. Your lender collects the money to pay your property taxes and homeowners insurance premiums as part of your monthly payment and then uses that money to pay those bills. That can be convenient, but there are a few other pros and cons to escrow accounts to know about, too.
What is mortgage escrow?
A mortgage escrow account is an account your lender or mortgage servicer establishes to hold the money you pay to it for taxes and insurance. The lender pays your local real estate taxes and homeowners insurance from that account when they come due. Depending on where you live, you may pay property taxes once or twice a year. Insurance premiums are usually paid annually.
You pay into the escrow account with every mortgage payment you make. The lender estimates how much it expects your taxes and insurance to cost for the year, divides the total by 12 and adds that figure to your mortgage bill each month. That way, when the bills come due, the money needed to pay them is sitting in the escrow account.
An escrow account can be a convenient way to save up the money for the important bills that come with homeownership. If you don’t pay your real estate taxes, the county can place a lien on the home. If you don’t pay for multiple years, the county can sell the property to recoup the taxes you owe. If you fail to pay your insurance premium, the insurer will cancel the policy, leaving you with no coverage if your home is damaged in a fire or storm.
Escrow account uses
Lenders use an escrow account to hold your money until the tax bill or insurance premium is due. Some lenders may also escrow homeowner association fees. The lender is protecting the investment it made in your house by ensuring the taxes and insurance are paid, helping to avoid tax liens and uninsured disasters.
You begin paying into the escrow account when you close on your mortgage. At closing, your initial escrow payment will likely be equal to one-sixth of the expected property tax bill and insurance premium for the home, but it could vary based on your lender. After that, you pay monthly.
When your property taxes or insurance premium is due, the mortgage servicer will withdraw the money and pay. If your bill is higher than expected and there’s not enough money in the account, the servicer will cover the amount. (Eventually, you’ll make up for the shortfall.)
Once a year, the lender is required to analyze your escrow account to make sure it’s collecting enough money but is not collecting too much of your payment. The lender can maintain a “cushion” equal to one-sixth of your annual escrow amount as a reserve in case taxes or insurance costs rise.
If the lender hasn’t been collecting enough, your mortgage payments will go up to cover the amount needed, including any money the lender paid out for taxes or insurance because of a shortfall.
If the lender has been collecting too much, you’ll get a refund, and your mortgage bills for the next year might decrease.
Mortgage escrow account benefits
An escrow account allows you to pay your taxes and insurance in installments. Benefits to an escrow account include:
- Convenience: Having your lender handle your tax bill and insurance premium takes those issues off your plate. You don’t have to keep up with details like when the bills are due, where to send the check and whether you have the money in your account.
- No big bills: If you don’t escrow your taxes, you could face a property tax bill of several thousand dollars each year. If you’re good at saving and budgeting, that bill might not be a problem, but many people find it difficult to come up with those funds. It’s often easier to pay off the amount in 12 monthly parts as part of your mortgage payment.
- Unexpected tax increases: Tax bills can go up for several reasons. Maybe your county raised the tax rate or it reassessed your home to a higher valuation. If your tax bill goes up, you’ll get a bigger bill than you expected, and that can squeeze your budget. When you escrow your taxes, the lender will cover the immediate shortfall, and you’ll make up the difference with repayment to the lender.
[ Read: Best Homeowners Insurance Companies ]
Mortgage escrow account drawbacks
While escrow accounts are convenient for some people, others see them as a drawback. Some of the drawbacks include:
- Higher closing costs: Since your lender may require up to one-sixth of your total annual tax and insurance payments at closing, you face higher closing costs at a time when you’re already forking over money for a down payment and other fees.
- Hard to get rid of: The rules vary based on the kind of loan you have, but in general, it can be difficult to get out of an escrow account. If you have an FHA loan, you must have an escrow account. VA loans don’t explicitly require one, but lenders usually insist on an escrow account to ensure you meet VA requirements for insurance and timely tax payments. Most lenders require an escrow account if you have a conventional loan, though you may get around it if you put at least 20% down.
- Lost opportunity cost: If your money sits in an escrow account for months on end, you lose the option to earn any interest or capital gains on that money. If you managed the money yourself, you could invest it or put it in an interest-bearing account until you need it.