What is escrow and how does it work?

Whether you’re a first-time buyer or a seasoned homeowner, it’s important to have a comprehensive understanding of the expenses and accounts associated with real estate transactions. Words you’ll consistently hear throughout the mortgage process are “escrows” or “escrow accounts.”

But what does escrow mean? In this article, we’ll define the various uses for both escrows and escrow accounts, plus define the effect on your mortgage.  

What is escrow?

Escrow refers to a financial and legal agreement that is designed to protect buyers and sellers during a transaction. Typically, a buyer and seller will create an escrow account with a neutral third party to pay for certain expenses, avoiding potential payment disputes.

There are a few other financial situations where escrow accounts are used (like the acquisition of stocks or even online sales). However, people most commonly associate the term with mortgages.

It’s important to note that entering escrow is state specific and may vary depending on your location.

What is an escrow account in a mortgage?

An escrow account is a financial tool used to manage the costs related to mortgages, such as down payments, insurance premiums, real estate taxes, etc. This type of account protects buyers and sellers throughout the homebuying and lending process as it allows a third party to hold money and important documents until both parties meet the terms of agreement.

In a home purchase, there are two types of escrow accounts:

• Homebuyer escrow — This type of account is used to hold earnest money* for the home on behalf of the buyer and seller.
• Homeowner escrow — Used to hold a portion of the monthly mortgage payments for the homeowner and their lender.

* Earnest money refers to a good faith payment made to the seller that they get to keep if you decide to back out of the deal. Usually this payment is 1% to 3% of the home’s purchase price.

How does escrow work?

Though homebuyers and homeowners both use escrow accounts, there are a few differences in the way each account type works.

Homebuyer escrow

When the seller accepts your offer, both parties enter into a purchase agreement. Your earnest money will then be held in a homebuyer escrow account until you and the seller satisfy the purchase agreement terms. These terms include:

• Mortgage approval
• Home value appraisal
• Home inspection
• Purchasing homeowners insurance
• Completing required repairs
• Conducting a final walk through

Once a buyer and seller decide to proceed with the sale, the funds held in the account will typically go toward paying the down payment or closing costs. A closing agent will confirm both parties have upheld their end of the agreement before releasing the earnest money and closing the escrow account.

Homeowner escrow

While a homebuyer escrow account is active until closing day, a mortgage or homeowner escrow account will remain open until the mortgage loan is repaid. This type of escrow account holds funds for expenses like:

• Private mortgage insurance premiums (PMI)
• Property taxes
• Homeowners insurance premiums

Escrow disbursement

Escrow disbursement is when payments are made from your escrow account. Expenses, like property taxes and PMI, are generally collected as a part of your monthly mortgage payments. Your lender will manage these funds in a homeowner escrow account and pay the bills on your behalf to reduce the risk of missed payments.

It’s important to keep in mind that escrow expenses, like PMI, may not be required if you put down more than 20% on a conventional mortgage.

Escrow mortgage payment

Your escrow account is funded each month as a part of your total monthly mortgage payment. Lenders typically split your monthly payment in three — a portion will go toward the mortgage principal, another will cover interest, and the rest will be put into your escrow account balance. 

Escrow balance

As it relates to mortgages, your escrow balance refers to the money that is set aside for your lender to use to pay for taxes and insurance. Your mortgage principal, however, is the amount you still owe on the home loan.

Lenders are usually required to send borrowers an annual mortgage escrow report that highlights a breakdown of charges. This annual analysis should also include projections for the upcoming year to help determine the amount you need to put into your escrow account month to month.

Escrow surplus

Some years your escrow costs may be lower than anticipated, meaning your account may have a surplus of funds. In cases where the surplus amounts to $50 or more, a surplus check will be included in your annual escrow analysis for you to cash and use as you see fit. If it’s less than $50, the money will remain in your escrow account to be used for future expenses.

Escrow shortage

If there aren’t enough funds in your escrow account, it’s called an escrow shortage. This may occur if prices for taxes and insurance premiums have increased. When a shortage happens, your lender will cover the costs then divide the amount evenly to be applied to your next 12 mortgage payments to make up for the difference.

Escrow advance

Though you can’t take money out of your escrow account, in the case of an escrow shortage, your lender will provide an advance using their own funds to cover your expenses. Think of it like a short-term loan — your lender will divide and apply the amount you owe on the advance to your monthly mortgage payments for the next year.

Here’s an example of how an escrow advance can affect your monthly payments:

While it ensures you remain on your current insurance and your property tax payments are made on time, depending on the amount of escrow advance it may add hundreds to your monthly payments.

Similar to other financial accounts, a homeowner’s escrow requires regular monitoring. The annual analysis provided by your lender is a big help, but it’s always best to keep track of your insurance premiums and property tax bills to avoid a surprise escrow shortage.