As a first-time homebuyer, by the time you reach the closing table, you have been bombarded with dozens of different calculations, percentages, and unfamiliar terms. One of the new terms that can be extra confusing is “escrow” because you will hear it used in more than one way during your homebuying journey.
What Is an Escrow Account?
In the context of a mortgage transaction, escrow is a financial arrangement between you, your lender, and a third party that securely holds your money until specific conditions are met. For example, when you go under contract on a house and make a good-faith deposit, those funds are held in escrow until closing.
However, escrow also refers to the account your lender sets up for you at closing, in which a portion of your monthly payment is deposited to cover homeowners insurance premiums, property taxes, and mortgage insurance, if needed.
The Ins and Outs of Escrow
Homebuyers are required to pay for a full year of homeowners insurance at closing. Some buyers choose to pay the premium straight to the insurance provider. Others place the money in escrow with the lender, who then transfers the payment to the provider.
Paying your initial property taxes is a bit less straightforward. In some states, taxes are paid in arrears, meaning you pay taxes for a period that has already passed. Traditionally, the seller pays prorated property taxes for the time they lived in the home, and you are responsible for the remainder of the tax year. This payment is included in the mortgage settlement and paid out of escrow.
Going forward, at the beginning of each new year, your lender will add up your estimated property taxes, homeowners insurance payments, and mortgage insurance (if applicable), divide the total by 12, and add that amount to your monthly mortgage payment.
When you make your payment each month, that extra money is placed into an escrow account. Unlike the escrow used during closing, this account is managed by your lender to store the money they will use to pay your property tax, homeowners insurance, and mortgage insurance bills when they are due.
Benefits of an Escrow Account
The primary benefit of an escrow account is that you don’t have to remember to set aside money each month toward your property tax payment and homeowners insurance premium. Your lender takes care of that for you.
Tax payments from your escrow account adhere to local and state requirements that determine whether taxes are due quarterly, semi-annually, or annually. So not only do you avoid the surprise of a giant bill at tax time, but you also don’t have to keep track of when that bill is due.
In short, an escrow account gives you the convenience of one monthly bill and the peace of mind that your homeowners insurance, taxes, and mortgage insurance are paid on time. If a payment is late, your lender is responsible for the penalties, not you.
Frequently Asked Questions about Escrow Accounts
Do I have to set up an escrow account?
It depends on who your lender is, where you live, and what type of loan you have.
Some lenders calculate your loan-to-value ratio to determine whether you need to set up an escrow account. Escrow is generally required if you have less than 20 percent equity (10 percent in California).
Additionally, for certain non-conforming loans—such as Federal Housing Administration (FHA) mortgages and U.S. Department of Agriculture (USDA) home loans— lenders and services will require escrow regardless of the down payment amount.
Homeowners insurance and estimated taxes can significantly impact your monthly mortgage payment. Using a mortgage calculator early in the home buying process can give you an idea of your future payment so that you don’t have sticker shock later.
What happens if I don’t have enough in my escrow account when my insurance or tax bill is due?
When it comes time to make your insurance and tax payments, there may not be enough money in escrow to cover them because your insurance premium went up or the tax estimate was off.
If you have underpaid, your lender will pay the difference, and your escrow account will go into the negative. But don’t panic!
At the beginning of each year, your lender recalculates your estimated taxes and current insurance premium, including the deficit. Your monthly mortgage statement will be updated to reflect this change. Additionally, you can pay a lump sum to “catch up” on the deficit.
What happens if I have more money in my escrow account than I need when my insurance or tax bill is due?
If you have overpaid into your escrow account, your lender will pay the tax and insurance bills, then give you the option of receiving a refund for the overage or keeping that money in escrow as a buffer.
Can I request an escrow account even if I don’t need one?
Yes! Whether or not you have an escrow account, you have to pay insurance premiums and taxes every year. Setting up an escrow account with your lender is a stress-free way to make these payments without a giant outlay of money at the end of the year.
Have More Questions About Escrow Accounts?
BNC Mortgage Lenders has been turning homebuyers into homeowners for decades. If you have questions about escrow accounts—or anything else mortgage-related—we’re here to help. Contact us or apply now, and one of our knowledgeable mortgage lenders will be in touch.
About the Author
BNC National Bank
We’re honored to be your partner in the homebuying process. And like any good relationship, it helps to know who you’re working with. A home is the most important purchase we can make in a lifetime. At BNC, we’re built to deliver exceptional customer service from your first call to your closing day and beyond. BNC National Bank has helped families find the right loan to fit their needs for decades.