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What Is Escrow And How Does It Work?

5-Minute Read
Published on July 24, 2019

When you obtain a home loan, the odds are high that your lender will require an escrow account.

You might have heard this term. You might even know that in most situations, an escrow account is reserved for money that your lender will use to pay your property taxes and homeowners insurance bills.

But you might not understand how these accounts work, how money gets funneled into them or why lenders require them.

It’s not surprising that home buyers often have questions about escrow accounts. After all, when you buy a home you might have to establish two different accounts: one before you finalize the purchase of your new residence, and the second after your mortgage loan closes.
To help eliminate any confusion, here’s a look at what escrow accounts are and how they work.

What Escrow Means Before You Buy Your Home

After you make an offer on a home, and that offer is accepted, you’ll typically come up with what is known as earnest money. You’ll 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 from this escrow account is released. 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, buyers will usually receive a refund of their earnest money.

What Escrow Means After You Close Your Mortgage Loan

The escrow account used to buy your home is a short-term account. 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, then will 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 makes sure 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 monthly payments (that could lead to a policy lapse) or unpaid taxes.

You will have to prepay some of your escrow costs at closing. 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, three 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 (one year’s worth of payments) which equals $400 a month. If your lender needs three months of property tax payments, you’ll provide three installments of $400, for a total of $1,200.

How Escrow Accounts Work

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 from year-to- year.

It’s also why your lender will perform an annual escrow analysis to assess your escrow account that makes sure you are 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.

A Possible Refund

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, a cushion of two extra monthly payments and an extra $50.

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 $8,450 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, plus that nit-picking extra $50.

However, if your taxes or insurance payments decrease and your lender collects more than this maximum in your account, they will send you a refund for the overage.

Consider the above example: If your escrow account has $8,450 and your annual property taxes and insurance bills come in at $6,000 (instead of $7,200), your lender will send you a check for $1,400 – a nice valuation that falls in your favor.

The math includes the federal allowance of the total yearly insurance amount of $6,000 plus two additional monthly payments ($500 per month) totaling $1,000, plus the additional $50 in your account. That comes out to $7,050. Subtract this number from the $8,450 in your account, and you get a refund of $1,400.

An escrow account is a helpful tool to make sure taxes and insurance payments are taken care of amidst the hectic schedules of our lives.