Takeaways
- An escrow account is created to receive deposits from a prospective home buyer.
- Funds remain in an escrow account until the homebuying closing process is finalized.
- Deposits in an escrow account can be reclaimed if the real estate transaction fails.
- Being “in escrow” starts when the seller accepts an offer and ends when a buyer officially takes possession of the new home.
- Regular monthly payments are deposited in a mortgage escrow account for taxes, home insurance, and private mortgage insurance.
Buying your first home can be an exhilarating process. Most buyers find themselves learning new terminology and vocabulary during the transaction process. These terms range from understanding how a mortgage works, to private mortgage insurance, and homeowner’s insurance. One of the most used new terms is an escrow account.
What is an Escrow Account?
An escrow account is a temporary third-party account held by two parties during a real estate transaction. During the home-buying process, you will put money into an escrow account for earnest money, various fees, and your down payment. The escrow account serves as a sort of holding place for the buyer and seller of the home to take each other and the process seriously.
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The escrow account is managed independently of the home-buying process. A home is said to be “in escrow” from when the seller agrees to the buyer’s offer to when the buyer takes the keys for the house. Once a transaction closes, the funds from the escrow account will flow to the appropriate parties. For example, the down payment will go to the mortgage lender who helps issue your closing documents.
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After you purchase your new home, you will most likely maintain an escrow account for the life of your mortgage. Your escrow account is where you will deposit funds for your estimated property taxes and various insurance payments.
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What is Included in Mortgage Payment?
When playing with your budget to determine home affordability, part of the calculus should be factoring in all the payments that go into a mortgage payment. Do not be caught off guard by only including your mortgage principal and interest payments. Many more costs will make up your monthly mortgage, and these costs will go into an escrow account.
Here are the costs that you will make monthly that also need to be factored into home affordability, fit with your long-term financial goals, and make sure you have ample cash reserves to cover other hidden costs of homeownership.
1. Mortgage Principal
A mortgage principal is the total amount of the loan you take to buy your home. Mortgage principal payments are made throughout the life of your loan. Mortgage lenders or banks will provide you with a repayment schedule for the life of your loan so that you can see exactly how much of your payment goes toward reducing your principal balance. You can increase the amount of your monthly payments that go toward your principal by making extra principal payments to reduce your overall loan.
2. Mortgage Interest
With each monthly check to your mortgage lenders, you will pay to reduce your principal and pay for the interest on your loan. In a time of rising costs and inflation, mortgage rates tend to be higher. If you have a high-interest-rate mortgage, you can refinance during periods of lower interest rates to make your mortgage more affordable.
Smart Tip:
The Federal Reserve sets the federal funds rate, which determines the base rate of how banks will lend money to customers. In 2024, the overnight lending rate hovers around 5.25%. And the 30-year fixed-rate mortgage is around 7%. High interest rates make owning a home challenging.
3. Property Taxes
Depending on where you live, property taxes will vary. They can also be one of the factors that cause your monthly mortgage payments to fluctuate from year to year. Mortgage providers will help estimate your property taxes and assign how much they believe you should put into the account monthly.
4. Home Insurance
Home insurance is typically mandated insurance by your mortgage provider. This payment ensures your home is protected from catastrophic natural disasters and other events that could cause the permanent loss of your house and property.
5. Private Mortgage Insurance
If you are not paying at least 20% of the home's purchasing price as a down payment, you will need private mortgage insurance (PMI). PMI is an additional expense to help offset the mortgage lender’s risk that you will default on your loan because you could not make mortgage payments.
Who Pays for the Escrow Account?
The short answer is - it depends. Who pays the escrow fees for the real estate transaction depends on how the fee structure is negotiated. In some real estate markets, the seller and buyer agree to split the escrow fees. In other markets, the buyer or the seller exclusively pays for escrow fees. Ultimately, who pays for the escrow account should be negotiated before you make an offer on a house so that you know the total transaction cost.
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Why To Use an Escrow Account
An escrow account helps you spread costs that are due annually over a monthly payment schedule. In essence, an escrow account is a helpful budgeting tool because it assists in scheduling periodic payments towards an annual cost. Most people have difficulty forcing themselves to save for a lump sum payment.
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Mortgage lenders know this tendency and do not want you to be caught off guard, unable to afford your annual property taxes, home insurance, or private mortgage insurance payments. Because of this, mortgage lenders and banks usually insist that you use an escrow account to make monthly payments to help them guide you to make your mandatory payments that are part of homeownership.
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Theoretically, you could not use an escrow account and make annual property taxes and insurance payments. However, if you fail to save for these payments, you could be responsible for heavy fines, liens on your home, or foreclosures. You and your mortgage lenders are incentivized for you to make on-time monthly payments so that you can maintain your property and house.
Advantages of an Escrow Account
Escrow accounts help millions of homebuyers by acting as a sort of holding bin for good faith deposits. They also benefit you after you buy your perfect house because they help manage your monthly mortgage payments. Here are several benefits of having an escrow account:
- Protects Your Deposits: Real estate transactions fall through all the time. For example, there could be a problem with the house's foundation discovered during the home inspection, or you could determine the advertised square footage is incorrect. These could be reasons that may cause you to terminate the agreement. Escrow accounts let you get your funds back quickly.
- Acts as a Budgeting Tool: Depending on the purchase price of your home and the local tax rates, your annual tax bill and insurance payments could be high. Instead of forcing yourself to save for these payments, an escrow account removes the burden of coming up with these high lump sum payments. Escrow accounts make your annual obligations manageable.
- Outsources the Work: Not only do you have the pressure to make annual tax and insurance payments, but you are responsible for calculating them as well. Your mortgage provider will take that off your plate and give estimated tax and insurance payments to streamline the payment process.
Disadvantages of an Escrow Account
There is nuance throughout the home-buying process. Here are several disadvantages to using an escrow account:
- Higher Mortgage Payments: Your mortgage lenders won’t know the exact amount of property taxes and insurance you will owe. Instead, they provide evidence based on the information they have at that time. Paying into your escrow account makes your mortgage payment higher than if you were only paying your principal and interest payments on your loan.
- Lost Interest Income: Technically, you could have your annual tax and insurance amounts saved in a high-yield savings account or certificate of deposit. Your funds would be growing at a faster rate than in your escrow account.
- Fluctuating Monthly Payment: Your mortgage lender or bank will provide annual assessments for property taxes and insurance. Because these vary from year to year, your monthly payments will change. Ensuring that your budget accounts for these changes in monthly payments will help you keep your home and make timely mortgage payments.
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Smart Summary
Having an escrow account is a regular part of the home-buying process. Familiarizing yourself with how an escrow account works and what causes escrow payments to change is a smart money move before buying a home. If you are working with a buyer’s agent, they should walk you through the process. Alternatively, if you are selling a home, your listing agent should have documents that thoroughly explain the working and utilization of an escrow account.
Frequently Asked Questions
Mortgage lenders do not collect homeowners’ association (HOA) fees. They also don’t cover utility bills for electricity and water use. These are managed separately and should be part of your monthly budget.
When you pay your monthly bills to your mortgage provider, part of your check will go to items in your escrow account, including your estimated property taxes and insurance payments. The critical phrase here is that these are estimated. For example, your actual property taxes might be lower than your estimated taxes, leaving you with a balance. You can apply this balance to your mortgage principal or leave it in your account as a buffer.
You will need a formal agreement with your escrow account provider, like setting up a checking or savings account. The escrow agreement defines the terms and conditions of the relationship between the three parties. An escrow agent manages your escrow agreement. Your mortgage provider and real estate agent will usually guide you through this.
