What is escrow and how does it work?

March 01, 2022

By Jamie Smith

What is escrow and how does it work?

A man researches escrow accounts.

An escrow is a financial agreement in which a third party controls payments between two transacting parties. If the money that is intended for a certain payment isn't gathered in full yet and is not due, it will usually be held in the escrow account. The money only releases under certain terms, usually when it's time to pay certain charges. The most common use of escrow is for a mortgage lender to pay for insurance and property taxes for a sold home. Let's cover what an escrow is and how it works.

What is escrow and what is it for?

Escrow is the use of a secure, independent third party when transferring funds. Technically, many things perform the function of escrow. Credit card companies can hold your money in escrow for a transaction temporarily in case you need to dispute or cancel the charge and get it back. Let's look at the subject from a real estate perspective.

Home mortgage payment escrow: How it works

Since buying a home is expensive, you’ll usually need a mortgage where you’ll make monthly payments. However, different factors go into the total monthly payment amount. Part of that payment balance is taken by the lender to go toward annual property taxes and homeowner insurance fees. These things are not paid monthly but the fees are put into an account monthly to help plan for those expenses.

When you make your total monthly payment, part of it goes toward your mortgage to pay your principal and interest, and another part goes to your escrow account. If you aren't paying for the home's insurance and taxes of your own, it's up to your lender to do so, and they'll do it by using a portion of your payments every month. The lender receiving your payment takes out a certain amount to keep in the escrow account. The money stays there, and by the time taxes or insurance are due, the escrow account should have accumulated enough for the lender to pay it.

Most people paying off a home prefer to pay the same amount every month, averaged out to cover annual expenses. A mortgage payment escrow is convenient for both parties. The lenders get to pay off these expenses when due, knowing the money will be there. An escrow account is an easy way to manage property taxes and insurance premiums for your home because you don’t have to save for them separately.  When these bills are due, they’re paid on your behalf.

Understanding escrow for mortgages and property fees

Escrow can be utilized in a variety of financial and legal situations in which anything valuable is exchanged between two parties. In real estate, it typically refers to an account for holding tax and insurance dues, although escrow can also be a part of buying a home.

All escrow really means is a safe, agreed-upon place to hold funds between two transacting parties. Mortgages frequently require tax and insurance payments, and it's wise to store those to-be-paid funds in a place both parties know about and agree about using.

Escrow ensures that a transaction goes smoothly and that any money that will be used toward that transaction stays securely in that account until needed. The lender putting money from your monthly payments into the account acts as the third party, ensuring a safe and timely payment.

What is a personal escrow account?

People can also open escrow accounts for themselves. For instance, if you have a mortgage, it's likely your lender is paying property taxes for you through a portion of your monthly payments. However, if you paid off your mortgage and own the house, then it would be  your responsibility to pay property taxes and insurance premiums, in which case you could create an account by yourself through a reliable credit union and use that to store the funds in escrow, effectively budgeting out the payments on your own.

Understanding escrow for buying a house

There is one other common use for the term escrow in real estate, besides for insurance and taxes. The first time you'll likely notice the term is when actually buying a house, as the seller typically requires an earnest money deposit kept in escrow. This protects both sides from various risks.

Earnest money vs. down payment: What's the difference?

An earnest money deposit, or good faith deposit, acts as a promise from the homebuyer to the seller that they will indeed buy the home, proving their intent by depositing some money upfront. Earnest money can vary between 1% to 5% of the sale and usually goes toward the down payment if everything goes through.

For now, let's continue to focus on mortgage payment escrow accounts.

What if my mortgage lender doesn't calculate escrow correctly?

There are protocols lenders are expected to follow when calculating mortgage escrow. For example, they should run an escrow study once a year based on fluctuating property taxes and insurance premiums. This alerts the lender to how much money they'll need to gather in the escrow account over the year to pay these dues when it's time.

Month by month, your lender will determine how much money you'll need in your account over the next year. Your lender will then estimate whether you'll have a shortfall or an excess. Following the analysis, you'll receive a statement detailing any changes to your account. If the lender happened to have extra money in your escrow account of $50 or more, that overage money is yours. They’ll usually send you a check for any extra money in your escrow at the end of the year. But the opposite could also occur.

What is mortgage escrow shortfall?

Escrow shortfall or shortage is when an escrow account does not have enough funds to make an incoming required payment. Your lender will be required to send you notification of liability payments such as insurance fees, as they are trusted to take the funds month to month out of your payment and save it appropriately. Their report may also notify you of an account shortfall and give you options to repay it.

Homeowners with an escrow account in shortfall can choose to pay the remaining balance required all at once or by paying extra on the monthly mortgage. The letter from your lender should tell you how much the shortage is and how much your monthly payment will increase if you don't pay it all at once. Keep in mind that escrow is not for interest on the mortgage, but property fees.

Escrow is a fairly simple term once you consider the different risks involved in transferring money. A third party secures money from one party until it is ready to transfer to another. In real estate, this could refer to buying a home and putting an earnest money deposit in escrow, or it could refer to an account that stores infrequent, variable payments such as property taxes. We hope you found this helpful.

Want to learn more about mortgages? Check out these other articles:

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