What is escrow?

Smiling couple seated at a table review escrow account details with their real estate broker.Image: Smiling couple seated at a table review escrow account details with their real estate broker.

In a Nutshell

An escrow account is a typical part of the homebuying experience. You can use escrow funds to pay property taxes, insurance and other required payments associated with your mortgage.
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Let’s look at what escrow is and how it works, whether you’re required to use an escrow account, and why your lender might require escrow for the home loan.

What is escrow and how does it work?

When you make an offer to purchase a property, it’s standard to make a deposit or pay earnest money to show the home seller that you’re serious about buying the property. But you don’t just pay the deposit directly to the home seller. Instead, your real estate broker puts the deposit funds into an escrow account, which is an account where your money is held for safekeeping.

If you decide to move forward with the home purchase, your deposit in the escrow account is applied toward the down payment and closing costs. If your offer isn’t accepted, your money will likely be returned to you.

Mortgage lenders also use escrow accounts to collect payments for property taxes, insurance and other items on a monthly basis. The mortgage lender pays the amounts owed directly to the municipality and home insurance company in your name to ensure that your accounts remain in good standing.

Do I have to use escrow?

You don’t necessarily have to use escrow. It depends on the mortgage lender and the type of mortgage that you have. Some lenders require you to pay expenses, such as property taxes and home insurance, via an escrow account, while others may not. Escrow may be required in cases where you’re required to pay for private mortgage insurance.

If you’d prefer a lender who doesn’t require escrow, you might need to shop around.

What kinds of home loans require escrow?

It depends on the mortgage lender and the type of mortgage you’re signing up for. If you’re making a down payment of less than 20% on a home, you may need escrow for the mortgage insurance premium that may be required.

If you’re building or remodeling your own home and taking out a construction loan, your lender may also require escrow to pay for materials, labor and other construction expenses.

Who accesses the escrow account?

If you’re making the deposit on a home you want to purchase, the real estate brokerage will have access to the escrow account. It’ll deliver the money to the home seller if your offer is successful. In that situation, your money is applied against the down payment on the property. If your offer isn’t successful, the real estate brokerage will return your deposit money to you.

If the escrow account is for a home you already own, your mortgage lender will have access to your escrow account. The mortgage lender will use this account to deliver funds owed to the municipality for property taxes and to the insurance company for home insurance.

Why is escrow used for property taxes and other payments associated with my mortgage?

Escrow accounts can be used to pay property taxes, home insurance and other payments associated with your mortgage. If you don’t use escrow funds for these payments, you may be at risk of making late payments or overlooking them entirely. Missing such payments can have serious consequences beyond a simple late fee.

If you don’t pay your property taxes, for example, the city could place a lien on your home — and depending on the state, you could lose your property if it’s included in a tax lien sale.

By requiring that you use an escrow account to cover property taxes and other recurring costs, your lender can ensure these expenses are paid on time.

Important escrow account rules

Depending on what part of the homebuying and homeowning process you’re required to use escrow for, there are some rules you should know. For example, if you make an offer on a home, be aware that, subject to state law and the rules of your loan program, it’s possible that you could lose your deposit if you don’t move forward with the home purchase in good faith if your offer is accepted.

In situations where you and the home seller mutually agree not to move forward, it can take some time for your deposit money to be returned to you from the escrow account. It may take several days to a week or longer for the money to be sent depending on state law and other variables. Make sure you anticipate that extra time, especially if you’re interested in making an offer on another property in the meantime.

In cases where you’re using escrow to pay property taxes, if there’s a discount for lump sum payments, the lender may (but is not required to) make an annual payment instead of an installment payment in order to take the discount and/or avoid added charges for paying the tax on an installment basis. Be sure to tell the lender if you have a preference.

For expenses that are billed in cycles longer than one year, lenders must collect these funds in equal monthly payments. In such cases (which may include flood insurance or similar costs) a two- or three-year cycle may determine what’s acceptable for the escrow balance rather than an annual one.

What’s next?

When buying a home, an escrow account can help you pay earnest money, make property tax payments and home insurance payments. If you’d prefer to pay your home insurance and property taxes yourself, you may need to shop around look for a lender willing to allow you to pay them without escrow.

About the author: Sean Cooper bought his first house when he was just 27 and paid off his mortgage at 30 in 3 years. An in-demand personal finance journalist, money coach and speaker, his articles have been featured in publications suc… Read more.