As a first-time homebuyer, you’ve probably heard the term escrow. However, chances are, you’re probably now wondering what exactly escrow is. When it comes to homebuying, the terms “escrow” and “escrow account” describe two different functions. Escrow is the process where a neutral third party mediates a real estate deal, holding money and property “in escrow” until the deal closes. Alternatively, your mortgage lender uses an escrow account after you’ve purchased your home, to manage your annual tax and insurance costs. So whether you’re buying a home in Albany, NY, or a condo in sunny Scottsdale, AZ, read on to learn more about the escrow process and how it works.
What is escrow?
Escrow is a legal term that means a deed, deposit, fund, or property is in the custody of a neutral third party. These third-party companies can include an escrow company, title company, or a law firm that services escrow. During the homebuying process, these companies mediate the real estate deal and hold money and the property “in escrow” until all the conditions from the purchase and sale agreement have been met. After the deal is complete, your mortgage lender will create an escrow account. This account will manage property tax and insurance premium payments on your behalf.
What’s the purpose of an escrow account?
Escrow accounts serve two functions – to protect earnest money until all conditions of the sale are met, and to hold homeowners‘ money for certain property expenses. These expenses are typically property taxes and homeowners insurance.
Your lender will estimate the total annual expenses and use the amount from the escrow account to pay them. They will add a prorated portion of this to your monthly mortgage payment, and pay the bills when due. This means that you don’t have to worry about making large lump sum payments for property expenses once or twice a year. Your lender handles this for you.
Escrow accounts can be a convenient way to manage your tax and insurance payments. Anthony Sherman, the Co-Founder and CEO of Simplist, a company that specializes in simplifying the complexities of getting a mortgage, outlines the benefits of escrow accounts saying, “Consider establishing an escrow account when you purchase a home. In one easily deducted monthly payment, you’ll cover your property taxes, homeowner’s insurance, and mortgage. Since taxes and insurance are typically due only once or twice a year, planning for those large expenses can be more cumbersome than just spreading them out over 12 months and not worrying about it.”
The lender pays the tax and insurance payments in whatever interval the recipient specifies. For homeowner’s insurance, this will probably be once a year. For property taxes, payments could be between one and four times a year, depending on where you live. Sherman goes on to say, “Escrow accounts also ensure that you avoid late fees and missed payments, plus, your escrow reserve account covers any future increases in property taxes and/or insurance. While an escrow account simplifies your personal finance, do consider that this also means that you must give your lender reserves to cover those potential increases.”
Additionally, your lender will send an annual escrow account statement showing the transaction history and any changes for the coming year. They won’t necessarily send this document on December 31—it can be on the mortgage anniversary or some other date.
Why is escrow important?
To get comfortable with the concept, try to picture where the money would end up if there were no escrow accounts. Who would hold each party responsible to fulfill the home sale conditions? The escrow agent facilitates the sale. All conditions of the sale must be met before the title and money are released. For example, say the home inspection uncovered a significant problem, and the seller agreed to get it repaired. At the final walk-through, you discover that the seller hasn’t made the repair yet. If the issue is not resolved by then, you can delay closing. The escrow account is also important for new homeowners. Your local government requires you to pay property tax once or twice a year. And with an escrow account, you don’t have to pay it all at once.
According to Natalia Sishodia, New York City Attorney and the Managing Partner of Sishodia PLLC, “Most banks now require escrows to be held for taxes and sometimes homeowner’s insurance too. This is simply because banks want to make sure the borrowers pay their homeowner’s insurance, and even more importantly, their real estate taxes. If a borrower doesn’t pay their real estate taxes and there is a lien against the property, the tax lien takes priority over any liens the bank may have to enforce in the case that a borrower defaults on their mortgage payments.” She goes on to say, “By escrowing, banks are given control and can ensure the taxes and insurance get paid and on time.”
What is the escrow process?
The escrow process begins when the seller accepts an offer to purchase a property. The neutral third party will hold onto the newly deposited earnest money from the buyer and the property from the seller. The first escrow process can last anywhere from 30-60 days, depending on various factors. These factors can include problems arising during inspections, bank delays, unknown liens, or any agreed-upon repairs. When both parties meet all the conditions of the sale, your lender will set up an escrow account. The lender will use this account to pay the monthly taxes and insurance. The account is valid until the homeowner pays off the mortgage or refinances with another lender.
When does the escrow process end?
The homebuying escrow period ends when you close on the house. Closing is also referred to as the closing of escrow. The escrow agent will arrange the closing process, including presenting the purchase and sale agreement, lender instructions, buyer and seller instructions, and other documents for the parties to sign.
The closing also includes the payment of service fees for the escrow agent. These can range from hundreds to thousands of dollars, depending on the sale. The costs of escrow, including lender closing fees and title insurance, will typically be about 1-2% of the value of your new home. The service fees should be listed in the loan estimate you get from your lender before closing and could change until you receive the closing disclosure from your lender.
The escrow agent will transfer the deed to you as the buyer (or in some cases, to a trustee who holds title during the term of your mortgage), while the money is transferred to the seller.
As part of the escrow process, you’ll typically be depositing funds to cover 3-12 months’ worth of property taxes and insurance into an escrow account. And you’ll likely pay these funds at closing. You’ll pay your insurance company and a local tax collector depending on your title company and lender. They may appear as a pre-payment toward your lender escrow account or a combination of the two.
What are the advantages and disadvantages of an escrow account?
For many people, an escrow account is a good choice. It’s easy to use, it simplifies your saving process, and it’s relatively worry-free. Below are some insights into the advantages and disadvantages of an escrow account, as noted by Redfin agent Ali Donoghue.
- It’s a built-in savings mechanism. Property taxes are usually due only once or twice a year. This means that after months of making no payment, you’ll need to pay several thousand dollars to your local government. It‘s easy to be caught without the necessary funds if you haven’t been diligently saving for it. An escrow account equalizes your payments into regular, required monthly chunks.
- It means less worry for you. The bank takes on the responsibility of making sure your taxes and insurance are paid in time and in full. Your lender must pay the penalties associated with any mistakes and correct the situation if any mistakes are made.
- It’s easier to get a mortgage. Many lenders won’t offer a mortgage unless you agree to an escrow. It’s how they protect their investment. So, if you want the most options and best rates, you have to be willing to accept an escrow account.
- You have to pay upfront. This doesn’t seem like a big deal when interest rates are low. But imagine if you could get a 5 percent return in a money market account. That’s a return that you would forgo by contributing monthly payments to a lender. In other words, you could be investing your monthly escrow payment until the actual tax payment is due. This is what your lender is doing. (Note: Some states require that your lender pay interest to you for the money kept in your escrow account. Check with your lender to see if this is the case in your state.)
- It’s a perpetual cushion that you can’t access. The Real Estate Settlement Procedures Act (RESPA) allows lenders to keep up to two months’ cushion in your account, in case property tax or insurance rates go up. This means that some of your money will be sitting in the escrow account indefinitely until you either sell the property or pay off your loan. Of course, should your property tax bill jump significantly, the cushion can reduce or totally cover the pain of an unexpected extra payment – that’s the benefit.
- It results in less nimble money management. Here’s a scenario – you successfully contest your property assessment, and your tax bill goes down. You’ll get some money back, right? Well, yes and no. By law, your lender needs to assess your monthly payments at least once a year. So eventually, you’ll get the money back in the form of reduced monthly payments or a rebate check. But it may take quite a long time to happen. Or, on the flip side, if your tax bill increases 30 percent, your monthly payments will jump significantly. If this is the case, you may need to make an unexpected lump payment. So don’t let the ease of an escrow account lull you into a false sense of security. Always have some extra money saved for unexpected home-related repairs and expenses.
What if you don’t have an escrow account?
If your loan doesn’t include an escrow feature and you miss a payment on your property taxes or homeowner’s insurance, your lender likely has the right to open an escrow account to take over making the payments.
In addition, if you’ve missed a tax or insurance payment without an escrow account in place, your lender may turn to lender-placed insurance, also known as force-placed insurance. The lender can purchase an insurance policy on the home themselves to protect their financial interests.
What is force-placed insurance?
You may encounter force-placed insurance even when you have an escrow account. Specifically, if you fail to purchase or renew a required homeowners insurance policy. When the regular policy lapses or you cancel, this can also occur. For instance, if an insurer decides to no longer offer policies in a particular region. And it can also come into play if the bank decides that you need a specialized policy like wildfire, earthquake, or flood insurance.
Force-placed policies will cost more than what you could buy on the open market. They also have much less coverage and often don’t include liability insurance or coverage for personal items—only the structure itself.
If the lender decides to purchase a force-placed insurance policy for you, they’ll add the cost to your monthly mortgage payment. If you want to cancel it, you’ll have to show your lender that you’ve purchased a suitable policy.
You are likely to receive notification from the lender in any of these circumstances if you don’t maintain the required insurance. They give you a chance to correct the situation before turning to a force-placed policy. So, it pays to keep an eye out for any correspondence from your lender and insurer.
FAQs about escrow accounts
Will your monthly lender payment ever increase?
As long as you keep your loan with the same lender, you’re going to see the payment go up or down once a year. Even with a fixed-rate loan, escrow amounts can typically change every year to reflect changes in property taxes and insurance. They’re not typically interest-bearing. However, in about a dozen states, including California, lenders must pay interest on escrow accounts. Upon paying off your loan or refinancing, there will be an escrow balance left, which will be refunded to you.
What if your loan doesn’t include an escrow account?
If your loan doesn’t include an escrow account, you may be able to request one. There is usually no charge for opening an escrow account, but you may have to put down a substantial deposit. If payments are due only once a year and you open an escrow account just before your taxes are due, you’ll essentially be pre-paying for a year’s worth of expenses.
Can escrow accounts pay HOA dues?
If you’re buying a home in a community served by a condo or homeowners association (HOAs), your lender may be willing to pay your HOA dues through your escrow account, though this is not very common.
How does private mortgage insurance work in escrow?
If you’re making a down payment of less than 20%, the lender may require that you purchase private mortgage insurance (PMI) through them. Keep in mind this protects the lender, not you. Monthly escrow payments cover the cost of PMI.
What happens to the account once you pay off the loan?
When you pay off the loan to your home, you may have additional money left in your escrow account. If so, you will receive a check with the remaining balance. You’ll start paying the property taxes and homeowners insurance fees yourself. Escrow accounts and the escrow process may seem complex. It’s important to have a good understanding of how it works. That way, you’ll be able to confidently follow along with the escrow process as you buy your home, make mortgage payments, and eventually refinance or pay off your loan.