What is escrow and how does it work?

An escrow account holds money for certain expenses, like your property taxes and homeowners insurance payments, until it’s time to pay for them.

Although your lender will typically set up an escrow account during the homebuying process, some homebuyers don’t have one. If you don’t have a home loan escrow account, you’ll need to set aside money separately to cover these expenses.

It’s important to familiarize yourself with a mortgage escrow so that you’re prepared when the time comes to purchase your real estate. Here’s everything you need to know about escrow, how it works, the main types of escrow accounts, and when you might — or might not — need one.

What is escrow on a mortgage?

When you close on a mortgage loan, your lender or loan service provider will typically set up an escrow account. This account will hold certain expenses tied to homeownership, including homeowners insurance premiums, property taxes, and private mortgage insurance.

Keeping this money in a secure account ensures that your payments will be made on time. This reduces the risk to the lender and insurance companies that you’ll default on your mortgage loan.

Mortgage escrow accounts also exist to protect the buyer and seller during the homebuying process. If it’s set up before closing on the loan, the account can hold your good faith deposit known as earnest money. This is a small percentage of the home’s value and shows the seller that you’re serious about purchasing their home.

If you’re in the middle of the homebuying process, you might have also heard the term “being in escrow.” This means that certain things, like property or money, will not be released until the parties involved have met all of the conditions of the contract. Only then will the transaction be finalized.

How does an escrow account work?

When you get an escrow account, a portion of your monthly mortgage payments go toward things like property taxes and insurance premiums. The money is placed into this separate account where it remains until the payment is due. At that time, your mortgage service provider will use the account balance to make these payments on your behalf.

Since there are 12 months in a year, your loan servicer may require you to pay 1/12 of these fees every month. In some cases, your servicer will also add an escrow cushion to ensure there’s enough money in the account at the end of the year. This cushion will be a maximum of 1/6 of your total yearly payments.

Every so often, there will be an escrow analysis to determine whether you’re paying enough to cover your insurance and taxes. It will also determine what your monthly mortgage payment will be for the upcoming year. Because property taxes and insurance premiums can change each year, your monthly payment could also change.

If, during the escrow analysis, your servicer finds that there is not enough money in the account, they might require additional payments to make up for the deficiency. If there’s a surplus of at least $50, you’ll receive that money as a refund. If the surplus is less than $50, your servicer might credit it toward the upcoming year’s escrow payments.

Not every homeowner has an escrow account. If you don’t have one, you’ll be responsible for paying all taxes, insurance premiums, and other required costs yourself. If you don’t make these payments on time, your lender could tack on the cost to your loan’s overall balance, or your local or state government could place a tax lien on your home.

What is an escrow account used for?

Escrow accounts for mortgages serve two main purposes:

• Holding earnest money when you buy a home: As a potential buyer, you might decide to pay earnest money to show the seller you’re serious about purchasing their home. This money may be held in escrow until the sale is finalized. At that time, it will be applied toward the down payment or closing costs. If the real estate transaction fails through no fault of your own, the earnest money will be returned to you.
• Paying homeowners insurance and property taxes: After closing on the home, your lender or loan servicer may establish an escrow account. This account will last for the duration of the loan. It’s used to pay for property-related costs, such as homeowners insurance, private mortgage insurance, and property taxes.

When do you need an escrow account?

You probably need an escrow account in the following scenarios:

• Your lender requires it: Not every mortgage lender requires an escrow account, but some do. This also depends on the type of home loan you get.
• You have a “higher-priced” mortgage: If you have a “higher-priced” mortgage, like a first-lien mortgage or jumbo loan, you might be required to have an escrow account. You may need to keep this account for the entire loan term, though some loans let you remove it after five years.
• You struggle to stay on top of expenses: Having an escrow account can help you manage your property taxes and insurance premiums.
• You’re paying earnest money: Since your earnest money is held in escrow, you can rest assured knowing it’s safe until the time comes to use it.
• Your down payment is less than 20%: If you get a conventional mortgage with less than 20% down, you’ll typically be required to get private mortgage insurance (PMI). An escrow account can hold this insurance payment for you.

When do you not need an escrow account?

An escrow account can be beneficial, but it’s not always necessary. Here are some common reasons why you might not need one:

• You can afford a higher down payment: If you put down at least 20%, you might not need an escrow account since there’s no PMI.
• You can manage your expenses on your own: If you’re confident that you can pay for your insurance premiums and taxes on your own, an escrow account might not be necessary.
• Your lender does not require it: If your lender does not require it, you could opt out of an escrow account.

Who benefits from an escrow account

Since an escrow account is managed by a neutral third party, it keeps your money safe until it’s needed. Here’s who benefits from using an escrow account:

• The buyer: You, as the buyer, benefit from having your funds in an escrow account. If you paid earnest money when you made an offer, you should get that money back if you meet agreed-upon conditions; having the money in an escrow account ensures you’ll get any refund you’re owed. 
• The seller: In addition, sellers benefit from an escrow account if sale conditions aren’t met and the seller is owed earnest money. This might happen if the buyer backs out of the sale without an acceptable reason; the third party who manages the escrow account determines who should have the money, and pays it accordingly. 
• The lender: An escrow account helps make sure that property taxes and homeowners insurance are paid in full. Your lender wants to see these payments covered to protect its interest in the property. When you make your monthly payment, the portion of your funds that covers insurance and taxes will go into an escrow account, and a third party who manages the account will pay for these items when they’re due. This benefits the lender by guaranteeing there will be no lapse in insurance coverage or overdue taxes. 

Pros and cons of escrow

Using escrow comes with advantages and drawbacks, depending on your situation. Here are a few things to consider:

What is escrow FAQ

Do you get escrow money back?

You might get your escrow money back in certain situations. For example, if you pay off your entire mortgage, your loan servicer is required to return any remaining funds to you within 20 days. You could also receive a refund if you’ve paid a surplus of $50 or more to the account.

How much of a mortgage payment goes toward escrow?

Your servicer will determine your total annual escrow payment amount and then divide that number by the number of months in a year. This is how much will be deducted from your monthly mortgage payment for escrow.

Can I remove escrow from my mortgage?

Depending on state and federal law, as well as your mortgage contract, it's possible to waive the escrow account requirement. You might also be able to remove escrow after paying off your mortgage or building enough home equity to remove PMI from your loan.

Is there a fee to cancel escrow?

Canceling an escrow account may come with a fee. In Arizona, for example, if you cancel the account after 45 business days, you could be charged a $150 fee.

Who owns the money in an escrow account?

Although your loan servicer or lender manages the escrow account, the money still belongs to the person paying the money. The money is held in the account until it’s needed to pay for insurance, taxes, or other costs.