Understanding Escrow Accounts

An escrow account is a savings account set up and managed by your mortgage lender. The sole purpose of an escrow account is to ensure you have enough funds to pay your yearly property taxes and homeowners insurance.

It’s important to understand that an escrow account is different from the escrow process when you purchase a property. In that case, escrow is a legal arrangement where a third party, such as a title company, temporarily holds your earnest money, down payment, or closing costs until purchase conditions are met.

With an escrow account established, you’ll pay an escrow payment each month, which is roughly the total of your annual payments split into manageable monthly amounts. This takes a potentially overwhelming yearly expense and spreads it across the entire year.

Property taxes alone can be thousands of dollars annually. According to a U.S. Census Bureau survey, the median real estate tax paid in the U.S. is nearly $3,000. Failure to pay these taxes results in a lien against your property and in some states, defaulting on your taxes leads to foreclosure.

Most lenders require escrow accounts to make sure you stay current on these obligations and avoid additional liens on the property. With an escrow account, when an escrow item is due—like property taxes—the lender is responsible for paying the bill in full and on time.

How to Estimate Escrow Payments

To estimate your escrow payments, lenders combine the predicted cost of your homeowner’s insurance and your real estate property taxes. The latter is obtained from your county tax authority and is based on your property’s assessed value. The more valuable your property, the higher the assessed value and property taxes will be. It’s important to note that the assessed value is often less than a property’s appraised market value.

Property values often change, so most lenders require an additional escrow cushion of up to two months of escrow payments to protect your escrow account from shortfalls.

Also, your escrow payment is reviewed annually and adjusted. You could receive a refund for overpayment if your escrow account balance rises above the estimated amount and required cushion. If your property taxes and insurance are greater than your escrow balance—like in the event of unexpected market changes—this is called an escrow shortage. You won’t be penalized but will be required to pay extra for the shortfall.

Other Escrow Options

Some mortgage lenders allow established borrowers to close their escrow account, depending on the specific terms of the mortgage contract. For example, you may need to have a certain amount of equity in the property before your lender agrees to close your escrow account. Your vested interest is high enough that they assume you’ll continue paying these bills.

Without an escrow account, you’re responsible for paying property taxes directly to the right agency, and homeowners insurance directly to your insurance carrier. Some people prefer this approach because they are good at saving for larger expenses and prefer to earn interest on the savings themselves. Homeowners don’t earn interest on escrow account balances.

Only cancel your escrow account if you’re very confident you can plan for, manage, and pay for these important bills on time. Like the cushion required by the lender, it’s smart to include a buffer of your own in the amount you save towards these bills, so you’re not in a bad spot if the amounts owed increase.

Escrow account or not, it’s important to remember that payment of property taxes and insurance are part of your monthly and annual mortgage costs. When you can comfortably include all those payments in your budget, you can confidently afford a home.

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