What Is Escrow And How Does It Work?
When you get a mortgage, your lender will probably require you to put money in escrow.
Wondering what that means? Let’s have a look at what escrow is, what it’s used for, and how the process works for home buyers and sellers.
What Is Escrow?
Escrow is a legal agreement in which a third party controls money or assets until two other parties involved in a transaction meet certain conditions.
Think of escrow as a mediator that reduces risk on both sides of a transaction – in this case, the sale, purchase and ownership of a home.
How Does Escrow Work?
When it comes to real estate transactions, escrow is used to temporarily hold a buyer’s earnest money (or good faith deposit), which demonstrates a level of seriousness in following through with the eventual purchase of the home.
After the purchase is complete, escrow may also be used to hold a portion of the homeowner’s monthly mortgage payment, which is then automatically put toward the payment of taxes and insurance.
Escrow may be handled by a mortgage servicer, escrow company or escrow agent (sometimes called an escrow officer).
Let’s dig into the specifics of how escrow works for both of its main applications.
Escrow For Securing The Purchase Of A Home
After you make an offer on a home, and that offer is accepted, you’ll typically come up with earnest money. You (or your real estate agent) will deposit this money into an escrow account to show the home seller that you are serious about buying their home.
Once the real estate deal closes and you sign all the necessary paperwork and mortgage documents, the earnest money is released by the escrow company. Usually, buyers get the money back and apply it to their down payment and mortgage closing costs.
How much you’ll have to pay in earnest money varies, but you can usually count on having to come up with 1% – 2% of your home’s final purchase price. If you’ve agreed to pay $200,000 for your new home, you’ll typically have to deposit $2,000 – $4,000 in earnest money into an escrow account.
If a home sale falls through, buyers might not get their earnest money returned. For instance, if you change your mind and decide not to purchase the home, the seller typically keeps the earnest money. However, if the sale falls through because a home inspection finds serious problems with the house or it doesn’t appraise for a high enough value, the buyer might be able to receive a refund of their earnest money.
Escrow For Paying Taxes And Insurance
The escrow account used to buy your home is short-term. But after the closing, a second escrow account, opened by your lender, will be used through the life of your loan.
Most lenders require that you enter into an escrow agreement when you sign a mortgage contract. When calculating your monthly mortgage payment, your lender will calculate what extra money will be needed to maintain the mortgage, and then deposit this money into your escrow account.
When your property taxes and homeowners insurance payments are due, your lender will dip into this account and pay these bills on your behalf. This ensures that you won’t ever pay these bills late, and that your insurance provider and local government won’t place a lien against your house for missed insurance payments (that could lead to a policy lapse) or unpaid taxes.
You will have to prepay some of your escrow costs at closing. For example, your lender might make you pay upfront for your first year of homeowners insurance. If your policy costs $1,000, typically you’ll have to provide that amount at closing so that your lender can pay for your first year’s coverage.
You’d then start funding your second year of coverage – and every subsequent year thereafter – as part of your monthly mortgage payments.
How much you pay upfront to cover property taxes will depend on when your first property tax installment is due. Your lender might require, for instance, 3 months of property tax payments upfront to establish your escrow account.
As an example, if your property taxes are $4,800 a year, this means you’ll pay $1,200 into escrow to cover those taxes. This amount is calculated by dividing the $4,800 by 12 (a year’s worth of payments) which equals $400 a month. If your lender needs 3 months of property tax payments, you’ll provide three installments of $400, for a total of $1,200.
How Do You Set Up An Escrow Account?
Most of the time, an escrow account will be set up for you by your real estate agent.
In rare circumstances, such as when engaging in a private home sale, you may need to know how to set up an escrow account yourself. Banks and title insurance companies can both typically serve as escrow holders, as can some credit unions.
How Much Money Goes Into Escrow?
How much you pay into your escrow account each month will vary depending on the amount you pay for your property taxes and homeowners insurance each year.
Roughly, you can expect to pay one-twelfth of the total cost of your annual property taxes and insurance every month to keep your escrow account funded.
Say your property taxes are estimated to be $6,000 this year, and your insurance is expected to be $1,200. That’s a total of $7,200 for the year, or a monthly payment of $600. When you send in your mortgage insurance, you’ll have to include this extra $600, which your lender will deposit into your escrow account.
This is why you might hear the acronym “PITI” when lenders are talking about your mortgage payment. PITI stands for all the pieces of your monthly mortgage payment: principal, interest, taxes and insurance.
Determining how much you’ll need each year in your escrow account, though, is not an exact science. That’s because your property taxes and insurance premium can change year-to- year.
It’s also why your lender will perform an annual escrow analysis to assess your escrow account that makes sure you’re funding the right amount into it each payment period.
If your property taxes or insurance premiums rise, your lender might bump up your escrow payments to make sure you’ll always have enough money to cover these bills. If your taxes or insurance premiums fall, your lender might reduce the amount you need to pay each month.
You might also receive a refund check if your lender completes your escrow assessment and finds you have too much money in your account. This is often referred to as an escrow overage or surplus.
According to federal regulations, your lender can keep only enough escrow dollars to cover your yearly insurance and property tax bills and a cushion of two extra monthly payments.
So, for example, if your lender estimates your insurance and property taxes to equal $7,200 for the year, then your lender can keep a maximum balance of $8,400 in your escrow account. This figure includes the $7,200 to cover your tax and insurance bills, plus $1,200 to cover two extra monthly payments.
However, if your taxes or insurance payments decrease and your lender collects more than this maximum in your account, they’ll send you a refund for the overage.
How Can You Lower Your Escrow Payment?
Because it is directly tied to your property taxes and homeowners insurance, the best way to lower your monthly escrow payment is to lower the cost of one or both of those variables.
Shopping around for a new homeowners insurance provider may help you find a better rate that can, in turn, lower your monthly escrow payment. Disputing your property taxes, meanwhile, may be helpful if you believe your payments are too high for your home’s value, but any reduction will be dependent upon an appeal by a local assessor.
Do You Have To Use Escrow For Taxes And Insurance?
It’s possible to avoid escrow and pay your own taxes and insurance under certain circumstances. This will make your monthly mortgage payment lower, but you’ll have to make separate payments for property taxes and homeowners insurance.
If you’re buying or refinancing a home, you may be able to opt out of having an escrow account, but in certain instances the rules of the state you’re in may require you to have a certain amount of equity or a minimum down payment. In some cases, how you occupy the property may matter as well.
Even if you’re able to opt out, paying taxes and insurance through escrow can be a great convenience. Mortgages can be complicated enough, and this is one less thing homeowners have to worry about. With an escrow account, your property tax and homeowners insurance payments are split into more manageable monthly chunks paid throughout the year. Some people find this easier than having to write a large check in the summer and a larger check in the winter for their property taxes, as well as other checks to cover insurance premiums.
A Summary Of Escrow
Escrow is a common, sometimes required, part of the home buyer’s and homeowner’s journey. It serves to protect buyers and sellers alike during the sale of a home, and it ensures that homeowners make certain critical payments (like taxes and insurance) in full and on time.
Have more questions about escrow? Contact a Rocket Mortgage® Home Loan Expert.