When it comes to the home buying process, most first-time homebuyers are surprised to learn that their mortgage payment includes more than principal and interest on their home loan. They also have to pay a certain amount of funds into a mortgage account every month.
These accounts are called escrow accounts, and they’re used to ensure some crucial bills are paid on your home. When you pay into your escrow account, the lender will use the money in the account to pay your property taxes and premiums for your homeowners insurance.
That’s just the start of how these accounts work. So what is escrow on a mortgage and how does it work? Here’s what you need to know about escrow accounts.
What is mortgage escrow?
A mortgage escrow account is an account your mortgage lender or servicer establishes in order to hold and deposit the money you pay to them for specific property-related bills when they come due. Typically, mortgage escrow accounts are used for real estate taxes and homeowners insurance bills.
Lenders often require you to pay into an escrow account to be certain that taxes and insurance are paid on time. That way, the lender knows that the county won’t put a lien on your house for failing to pay taxes. It also ensures that the property they have a vested interest in remains insured against fire and other hazards.
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Paying into an escrow account prevents you from having to pay your entire tax bill in one payment. Think of it as an installment plan in which you pay a tax bill in 12 small segments rather than one or two large ones.
You’ll likely have to maintain an escrow account if you take out an FHA loan, a UDSA loan or a conventional mortgage in most cases. If you have a VA loan, the mortgage escrow account might be optional, but that’s not always the case.
How does an escrow account work?
The lender will begin collecting money for the escrow account at closing when you’ll make an initial escrow account contribution. After that, you’ll pay some money into the account each month with your mortgage payment.
When your property tax or insurance bill comes due, the lender or mortgage servicer will pay the bill by taking money out of the account. If there’s not enough money in the escrow account for the amount due, the servicer will cover the bill and collect it later.
The goal is to have enough in the account to cover the bills when they come due, but since taxes and insurance premiums can go up (or occasionally down), the lender can’t always predict how much to collect.
For that reason, the lender is allowed to keep a cushion in your account that can’t be larger than two months worth of escrow payments. The lender must also conduct an annual review of your account to determine if there is too much or too little money in the account. If the amount is too low, the lender will increase the amount of money you put into escrow each month to make up for the shortage. You may have the option to pay the deficit in a lump sum.
If there is too much money in escrow, the lender will send you a check for the overage.
Types of escrow accounts
As a homebuyer, you’ll encounter two different types of escrow accounts, so it’s a good idea to understand the difference in the escrow meanings.
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The escrow on a mortgage is the kind of escrow account just described. It’s an account tied to your mortgage payments and the lender collects money to pay your property taxes and homeowners insurance premiums. You’ll begin paying into this escrow account when you close on your mortgage loan.
You’ll encounter the other escrow account earlier in the homebuying process. Once you make an offer on a home and pay your earnest money, the money is deposited in an escrow account for safekeeping. A lawyer, closing company or another neutral third party maintains the escrow account, so neither the buyer nor the seller in the transaction holds the funds.
The third party’s job is to ensure that the seller and buyer have met all the real estate contract’s conditions before releasing the money. For example, if the sellers agreed to repair the deck, they can’t access the funds in escrow after closing until they uphold their side of the bargain.
Benefits of an escrow account
Once you understand what an escrow on a mortgage is, you can see some benefits of having an escrow account on your mortgage. An escrow account can reduce a few headaches related to homeownership, including:
- No surprise bills: With an escrow account, you are forced to save up for property taxes and homeowners insurance bills. You won’t have to scramble to find possibly thousands of dollars to pay your home taxes when they come due.
- Smaller payments: With an escrow account, you pay one portion of the yearly property taxes and homeowner insurance bills each month. Most people find it easier to make these installment payments than paying the entire cost at once.
- No forgotten bills: The mortgage servicer takes care of paying the tax bill and insurance premiums, so you don’t have to worry about due dates, mailing checks or other concerns that come with paying bills. These bills are ones you don’t want to be late on because failing to pay property taxes and maintain homeowners insurance can have severe consequences.
Drawbacks of an escrow account
There are drawbacks to having an escrow account, too. These drawbacks include:
- Higher closing costs: Since the lender can ask you to pay up to two months’ worth of escrow payments at closing, you’ll have to come up with more money for closing than you would without an escrow account.
- Higher monthly payments: The lender will add one-twelfth of the annual amount for property taxes and insurance to the amount you pay for principal and interest each month. That means your monthly payments are higher than they would be without an escrow account. Without the funds in escrow, you’d need to have all the money on hand when your taxes or insurance bill came due.
- No interest: The lender will hold the escrow money without paying you any interest. If the money wasn’t in an escrow account, you might be able to invest it or place it in an account where it could earn interest.