What Is an Escrow Account and How Does It Work?

Escrow is an important part of buying and owning a house. It protects and benefits homebuyers, home sellers, and homeowners. Sometimes an escrow account is required, and sometimes it’s optional, depending on the type of loan you get and your financial profile. Discover more about escrow accounts and how they work. 

What Is Escrow? 

Escrow is when an impartial third party temporarily holds onto money or property until certain contractual conditions are met. The idea is to protect both sides during large transactions, such as the sale of a home. 

Types of Escrow Accounts

Escrow has two uses in real estate applications — to protect the buyer and seller during the home buying process and to make homeowner’s insurance premiums and property tax payments more convenient. Here’s a closer look at how each account works. 

Escrow Accounts When Buying a Home 

When you make an offer on a house, the purchase agreement typically requires a good faith deposit (also known as “earnest money”). The deposit is placed in an escrow account rather than going directly to the seller, where neither party can touch it until the deal is closed. Assuming the sale goes through, an escrow officer will oversee the final paperwork at closing, ensure all necessary conditions are met, and apply the good faith deposit toward the down payment.  

While the money should come out of escrow at closing, sometimes the funds are held longer, a situation known as an escrow holdback. This can happen for several reasons. For instance, you may agree to let the seller stay in the house for an extra month, or you might find something wrong during the final walkthrough that needs to be repaired before the sale can be finalized. Likewise, if you purchase a newly constructed home, your funds may be held in escrow until you’ve signed off on the finished product. 

Escrow Accounts to Pay for Insurance & Taxes 

Your mortgage lender may establish an escrow account (also known as an “impound account” or “reserves”) after you’ve purchased a home to cover the cost of homeowner’s insurance and property taxes. If so, you may notice a line item labeled “escrow payment” on your mortgage bill. This amount may fluctuate because taxes and insurance premiums often change from year to year. 

Your lender will estimate your escrow payments for the next year and incorporate them into your monthly installments. Then, your lender pays these bills on your behalf before the due date. To ensure there’s always enough money, most lenders require keeping around two months’ worth of extra payments in escrow at all times. Keep in mind that escrow accounts don’t cover other homeownership expenses, such as HOA fees and utility bills. 

Who Needs an Escrow Account? 

It’s possible to pay your taxes and insurance without having an escrow account. Simply anticipate and save for these yearly expenses yourself. However, some types of mortgages require escrow accounts. Here’s what to consider: 

• Conventional loans: Borrowers must put 20% down to opt out of an escrow account. 
• VA loans: Borrowers must put at least 10% down and have good credit to opt out of an escrow account. 
• FHA loans: All borrowers are required to have an escrow account. 

Who Facilitates the Escrow Process? 

Various third parties can manage an escrow account during the sale and ownership of a home. The stage you’re at determines who facilitates the process. 

Escrow Companies & Agents 

When buying a home, an escrow company or individual agent may manage your escrow account. Some title companies provide escrow services, and closing officers and attorneys may serve as escrow agents. The escrow account fee, which is usually shared by the homebuyer and seller, is typically 1% to 2% of the final selling price. 

Mortgage Servicers 

Your mortgage servicer, which may or may not be the same company as your lender, manages your escrow account from closing until you pay off your home loan. It’s important to know the service level you can expect, as well as the fees involved, before you move forward. 

Benefits of Escrow 

Escrow accounts benefit everyone involved. 

• For homebuyers: Escrow is vital for protecting homebuyers against dishonest sellers. With an impartial third party controlling the funds, the seller can’t hold the good faith deposit hostage as a negotiating ploy. 
• For home sellers: Escrow also protects home sellers, who don’t want to sign over the deed to the house until the buyer has paid. 
• For homeowners: An escrow account eliminates the need to produce a lump sum for yearly tax bills and insurance premiums. For most homeowners, monthly installments are much easier to manage. Late payments also never occur, and the servicer should cover the difference if the escrow account ever runs short. 

Drawbacks of Escrow 

Homeowners are the ones who shoulder the disadvantages of escrow. 

• Higher mortgage payments: Escrow payments are built into the monthly mortgage, making these bills run higher than they would without escrow. 
• Potential for incorrect estimates: Mortgage servicers estimate insurance and tax payments for the year, but these figures may end up being inaccurate. Fortunately, any mistakes are easy to rectify. If the estimate comes up short, you pay your servicer the difference. And if you overpay into the escrow account, your servicer reimburses you. 
• Changes in monthly payments: Servicers may raise escrow payments based on that year’s insurance and tax rate estimates. Of course, you still need to pay any increased premiums and tax bills, even if you don’t have an escrow account.