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By Pam Leibfried
If you’ve ever bought a home, you’re probably familiar with the concept of an escrow account. But do you know why your realtor or lender set up your escrow account? And do you know how setting up your own personal escrow account can help you to be a better budgeter?
An escrow account is a financial account in which a third party holds onto your funds in the short-term for use at a future date. Escrow accounts are most often used in real estate to hold onto earnest money, prepaid closing costs, property tax payments and insurance premiums.
If you’re a typical homeowner paying a mortgage, each monthly payment you make includes a partial payment against the amount you owe (your principal), interest, a property tax payment and insurance. Your lender gets the principle and interest part of your payment and puts the portion that represents your insurance and property taxes into your escrow account each month. Your lender then uses that account to pay property taxes and insurance on your behalf when they are due, whether that’s quarterly, twice-yearly or annually.
Paying into the escrow account each month splits your insurance and tax payments up into smaller monthly bites, making it easier for you to budget for them. It saves you from being faced with a big annual or biannual expense that might be harder to save for and pay, especially if you’re someone who struggles with saving or budgeting. And collecting the money on a monthly basis also helps to protect the lender against loss, so it’s a win-win method.
You can open a savings account to use as your own personal escrow account. This will make it easier to budget for and pay all of your recurring expenses that happen on a routine – but not monthly – basis.
These personal escrow accounts aren’t really, technically, escrow accounts, because they’re not controlled by a third party. But the account can act just like a mortgage lender’s escrow account by letting you make smaller monthly “payments” in the form of transfers from your checking account to your escrow account, thereby making it easier to budget for non-monthly expenses.
For example, since I learned about this budgeting trick last year, I’ve set up two separate virtual escrow accounts to save for non-monthly expenses.
Most of these expenses – with the exception of my property taxes – aren’t for large amounts, and I had previously just paid them from my checking account. It never created a major budgeting crisis, but I do find it easier to set aside money each month so my budgeted expenses are more consistent from month to month. If you’re now living paycheck to paycheck and you struggle to save money, I think you’ll find this trick to be especially helpful.
You may be thinking that the accounts I described above sound like they’re just regular savings accounts. And technically, my escrow accounts are the same exact supplemental savings accounts as all my other Alliant savings accounts. But the difference is in how you think about these two account types and how you use them.
Regular supplemental savings accounts. Most savings accounts are all about working toward a specific one-time savings goal. For me, that means remodeling my kitchen and saving for a down payment on my age-in-place retirement home. For you, it could be a Harley-Davidson, a “she shed” or your dream vacation to Patagonia or Hawaii. You transfer money each month from checking to that savings account and you leave it there until you’ve reached your goal. Then you use the money for that single expense.
Personal escrow accounts. An escrow account, on the other hand, is not about saving for a one-time expense. It’s for predictable, routine expenses that occur every year. You transfer money from your checking account to your escrow account each month, and on the months when the budgeted expense hits, you transfer money back into checking to cover that expense. And because these expenses are predictable – I know when my insurance premiums and property taxes will be due each year, for example – you can set up a prescheduled transfer to move the money back to checking so you don’t have to remember that task when the time comes.
Setting up a new escrow account and automating transfers to and from the account is very easy to do and only takes a few minutes. The only part that I found to be at all time-consuming in setting up my escrows was going through my budget to find the predictable, recurring non-monthly expenses I wanted to pay with my escrow accounts. If you’re a budgeter too, you might want to set aside a few extra minutes the next time you review your budget. Look for budget items that might be a good fit for this escrow-account method. The one-time set-up will make your budgeted expenses more consistent from month to month and I think you’ll find that helpful.
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