What Is Escrow?

When buying a home, you’ll probably hear your lender or real estate agent use the word escrow. The term escrow has a few different functions, from the time your offer is accepted to the day you close on your home — and even after you become a homeowner with a mortgage.

There are essentially two types of escrow accounts. One is used throughout the home buying process until you close on the home. The other, commonly referred to as an impound account, is used by your mortgage servicer to manage property tax and insurance premium payments on your behalf.

What is an escrow account?

An escrow account is a contractual arrangement in which a neutral third party, known as an escrow agent, receives and disburses funds for transacting parties (i.e., a home buyer and seller). Typically, a selling agent opens an escrow account through a title company once you and the seller agree on a home price and sign a purchase agreement. When you’re buying a home, this escrow account serves two main purposes:

1. To hold earnest money while you’re in escrow
2. To handle and disburse the funds until all escrow conditions are met and escrow is closed

How does escrow work?

During the escrow process, the escrow agent will handle the transfer of the property, the exchange of money, and any related documents to ensure all parties receive what they are owed. This removes uncertainty about whether either party can fulfill its obligations and helps ensure that neither party is favored over the other.

What does in escrow mean?

When you hear the phrase “in escrow”, it means that all items placed in the escrow account (e.g., earnest money, property deed, loan funds) are held with an escrow agent until all conditions of the escrow arrangement have been met. The conditions usually involve receiving an appraisal, title search and approved financing.

What does it mean to close escrow?

To close escrow means that all of the escrow conditions have been met. You’ve received a home loan, and the title has legally passed from the seller to you. During the closing of escrow process, a closing or escrow agent (who may be an attorney, depending on the state in which the property is located) will disburse transaction funds to the appropriate parties, ensure all documents are signed and prepare a new deed naming you the homeowner.

What is an escrow payment?

The impound account ensures that the funds for taxes and insurance are available and that premiums are paid on time. Your lender doesn’t want you to miss a tax payment and risk a foreclosure on the home. They also don’t want you to miss a homeowners insurance payment, or they may be forced to take out additional insurance on your behalf to cover the home in the event of property loss or severe damage.

How monthly escrow payments work

Your lender will notify you 30 days before your next payment if the amount changes. You can also ask your mortgage servicer to walk you through the local impound account funding schedule that applies to your loan. If there are insufficient funds in your impound account to cover the taxes and insurance, your monthly mortgage payment may increase (even though your principal and interest will stay the same on fixed-rate loans).

Initial escrow payment at closing

Lenders usually require at least two months’ worth of insurance and property tax funds in the impound account at closing. The amount you have to prepay into an impound account for these costs is based on your location. Keep in mind that these funds aren’t additional closing costs. Instead, you’re prepaying extra months of home insurance and property tax bills that you would be required to pay when due. Your mortgage servicer will list the initial escrow payment amount due at closing on your loan estimate.

Your escrow analysis statement

Each month, your mortgage statement will show you how much you’ve accrued in your impound account. And each year, your mortgage servicer is required by law to send you an annual escrow account analysis showing you some of the following:

• The amount of funds received from you
• The amount of funds paid out for insurance and property tax
• An estimation of how much the escrow portion of your monthly payment may increase or decrease based on the premiums owed
• Notice if you don’t have enough funds in your account to pay the estimated tax and insurance due in the next bill (i.e., escrow shortage)
• Notice if you have a negative balance in your account that is owed to bring your account to current (i.e., escrow deficiency)

Is an escrow account required?

An escrow account for paying property tax and homeowners insurance is generally required by lenders who originate VA, FHA and conventional loans. In some instances, lenders may allow the homeowner to pay the property tax and home insurance as a lump sum instead of setting up an escrow account. If you waive escrow, be aware that some lenders may charge you a fee or an increased interest rate.

While you may not be required to set up an escrow account, you can choose to open one voluntarily to break up insurance and property tax payments into smaller amounts, keep track of payment due dates and avoid surprise bills at the end of the tax year.

Disclaimer: The information contained in this article is for informational purposes only and is not intended to be relied upon as financial or legal advice, guarantees or warranties of any kind. Reference to escrow accounts here refers to an escrow account established to facilitate the purpose of a new home.