Escrow Accounts: What Are They and How Do They Work?

If you’ve been through the process of buying a home before, or you know someone who has, you’ve probably heard the term “in escrow.” But you might not be sure what that means or why escrow is important to the home-buying process.

In this post we’ll walk you through a basic explanation of an escrow account, how it works, why it’s important and even some instances when you might not need one. Let’s get started.

What is an Escrow Account?

An escrow account is an account managed by a third party that collects, holds, and distributes money and documents until the conditions of a contract are satisfied. In the case of a home purchase and sale agreement, the third party could be a title company, an attorney, a lender, a loan servicer, or a private individual entrusted with the role.

An escrow account has different functions during the homebuying and homeowning process.

Escrow Accounts During the Homebuying Process

During the homebuying process, an escrow account holds the buyer’s good faith deposit (i.e. earnest money) that a buyer puts forward while they are under contract on a home, the seller’s deed for the home, and other documents related to the sale. Once the contractual obligations outlined in the purchase contract are fulfilled, the escrow agent (sometimes called a settlement agent) will collect the necessary remaining funds, arrange for the signing of closing documents, prepare a new deed for the house, and disburse money to the appropriate parties.

Escrow Accounts for Homeowners

If you used a home mortgage to buy your home, you may continue to use a different type of escrow account to pay your property taxes, homeowners insurance premiums, homeowner association (HOA) fees and mortgage insurance premiums (if applicable). A borrower can do this by having their lender’s servicer set up monthly escrow payments that coincide with their mortgage payments; then, when the tax and insurance bills are due, payment will be made directly from the escrow account. This helps to ensure borrowers stay up-to-date on these important payments.

How Does Escrow Work During the Homebuying Process?

Overall, an escrow account can be a conduit for transactions both during the homebuying process and homeowner experience, and helps give peace of mind to all the parties involved in the transactions. During the homebuying process, the parties involved in the escrow process are: the homebuyer, the seller, the buyer’s lender (if the buyer has arranged for a mortgage), the seller’s lender (if the seller has an outstanding mortgage on the property), and the escrow agent.

Opening the Escrow Account

Once the buyer and seller sign the purchase agreement, the buyer or seller’s real estate agent will open an account with the escrow company or an attorney named in the purchase agreement. The agent will then deposit the buyer’s good faith deposit into the escrow account in the form of a cashier’s check or have the buyer wire the good-faith funds to the account.

Transferring Escrow Funds for Closing

To “close escrow” on the home sale, the exact process will vary by state. But as part of the process, the buyer will deposit the remaining funds needed to close the sale (i.e. down payment and closing costs) into the escrow account via cashier’s check or wire transfer; and the lender will wire the loan funds to the escrow account. Once they have received the funds, the escrow agent will send the money to the seller, and if applicable, the seller’s lender to pay off seller’s loan and obtain discharge of seller’s mortgage loan.

How Does Escrow Work When You Own a Home?

If you arranged for an FHA, VA or other government mortgage to help you buy your home, your lender will likely require you to use an escrow account to pay your property taxes, HOA fees, homeowners insurance premiums, and mortgage insurance premiums (if applicable). This may also be true with a conventional loan if your down payment on the property is less than 20%. You can find out if an escrow account will be required by your lender on the first page of your Loan Estimate.

The parties involved in the escrow account of a homeowner are:

• The homeowner
• The homeowner’s lender
• The government entity to which the homeowner pays property taxes
• The vendor through which the homeowner has purchased homeowners insurance
• The vendor who is providing mortgage insurance on the loan
• HOA
• The escrow agent or loan servicer

If your lender requires you to pay your monthly housing payments using an escrow account, you can find out your estimated monthly payments on page 1 of your closing disclosure form and which payments will be held in escrow. Page 4 of your closing disclosure form will give you more information about your escrow payments.

A few considerations to keep in mind:

• Your lender will set up the mortgage escrow account for you when you close your loan. If your lender requires you to prepay any of your property taxes or insurance premiums at closing, they will deposit those into your escrow account.
• Your lender or loan servicer will maintain your escrow account. The loan servicer is a company to which the lender retained to collect your monthly payments in order to pay your mortgage payment, property tax bills, homeowners insurance, HOA fees, and mortgage insurance payments.
• The manager of your escrow account (i.e. lender or loan servicer) will pay your property taxes, homeowners insurance premiums, and mortgage insurance premiums from the money in your escrow account.
• Once you achieve at least 20% equity in your home, you can ask your lender to close your mortgage escrow account and pay for your homeowner expenses directly.

Benefits of Having an Escrow Account

As a homeowner, many expenses come up infrequently or only once or twice a year. Those expenses include your property taxes, homeowners insurance, and your mortgage insurance premiums.

It can be challenging for homeowners to budget for these types of expenses, which is why maintaining an escrow account can be beneficial. Here’s how escrow accounts can benefit all parties involved with the purchase of a home.

• It’s easier for the borrower to budget for a portion of the property tax payment and insurance premiums every month, instead of coming up with a large lump sum all at once.
• The lender can have peace of mind knowing the homeowner is current on their property taxes so that no tax lien will be levied against the home. This is important because if the lender forecloses on the property, they will want to make sure they don’t owe any other expenses.
• The lender can have peace of mind knowing that if something happens to the home, the homeowners insurance coverage can help replace the damage.
• The borrower can be given the convenience of paying one sum, to one place, at the same time every month, as opposed to paying multiple vendors on different due dates.

In a nutshell, having an escrow account set up can help to prevent late payments.

Is an Escrow Account Required?

Regulation Z in the Truth in Lending Act requires lenders to establish escrow accounts for higher priced first mortgages. For most lenders, that pertains to a loan that is more than 80% of the home’s value. This rule requires lenders to maintain the escrow accounts from one to five years.

There are some instances when an escrow might not be required:

• The home mortgage is less than 80% of the home’s value.
• The mortgage lender is a small creditor that operates in a rural or underserved area.
• If the home is a condo, the homeowner is exempt from escrowing homeowners insurance payments.

Ongoing Management of Your Escrow Account

Your escrow account is similar to your checking or savings account. When you look at your account statement, you should see a record of all the payments you’ve made (credits), the disbursements the lender or loan servicer has made on your behalf (debits), and your escrow balance. To ensure your property taxes and insurance premiums are being paid, you will want to review your escrow account balance regularly (at least once a year).

It is federal law that you should receive an escrow analysis from your lender once per year that notifies you of any surplus or deficit in your escrow account. If there is an account shortage, that means your lender may have underestimated the cost of your property taxes, or another charge, and therefore didn’t collect enough money from you to cover the payment or your tax rate increased.

If there’s a shortage in your account, your lender can request you pay for that shortage immediately. If there is a surplus in your account that exceeds $50, your lender must return that surplus to you.

The Bottom Line

An escrow account is an account managed by a third party to collect, hold, and distribute money and documents in order to facilitate a financial transaction. It is the central repository during the homebuying process and helps facilitate a homeowner’s mortgage, property tax, and insurance payments on a monthly basis. These accounts play a crucial intermediary role for buyers, sellers, homeowners, and lenders, and ensure on-time payments and the correct distribution of funds.