An escrow account is a broad term that refers to money held by a third party for the purpose of two other parties conducting a transaction, but is most commonly used for real estate purposes.
Typically, an escrow account refers to money that is paid with a mortgage, but is set aside in a separate account in order to pay annual expenses, such as taxes and insurance. Another common type of escrow account is an account where funds are held prior to the completion of a real estate transaction, typically by a closing attorney or title company. For the purposes of this article, we'll focus on these real estate escrow accounts.
Escrow accounts -- before you close on a property
When you buy a house, there are several different cash amounts that must be paid by several parties, and paid out to a variety of other parties.
For example, upon acceptance of an offer, the buyer generally leaves an "earnest deposit," which is then held in escrow. At closing, the buyer is responsible for contributing the remainder of their down payment and closing costs, and the mortgage lender is responsible for transferring the loaned funds into the escrow account.
After all the funds are received and the loan is closed, the attorney or title company holding the escrow account distributes the funds. The largest check goes to the seller (usually) or the property's lienholder, but funds may also be distributed to real estate agents, insurance companies, appraisers, and county record keepers, just to name a few.
In short, the escrow account is intended to insure a smooth closing process with a neutral party making sure everyone gets the correct share of the funds involved.
How escrow accounts can make your life easier after you close
After you close on the house, you'll probably have to deal with another type of escrow account, designed to make sure large expenses such as property taxes and homeowners insurance get paid on time.
Generally, when you close on a house, your lender will require you to immediately deposit a portion of your annual taxes and insurance (the exact amount depends on your lender and when the bills are due), and then make additional payments each month while paying the mortgage. For example, if your taxes and insurance add up to $4,000 per year, your lender will add one-twelfth of that amount ($333) to your mortgage payment each month to be placed in an escrow account.
Why lenders use escrow accounts
From a lender's perspective, the purpose of having an escrow account is to make sure the property taxes and homeowners get paid every year, on time, to prevent any risk to their investment -- after all, the bank "owns" a portion of the home until you pay it off.
If homeowner's insurance isn't paid, the bank could have trouble recouping its investment in the event of a fire or other disaster. And, if the property taxes aren't paid, the state or local government could assess fines or even place a lien on the home.
In order to prevent these situations from occurring, the bills for these expenses are sent directly to your lender, and are paid out of the escrow account. However, it's important for homeowners to know that even though the bank holds your funds and is supposed to pay the bills, they are ultimately your responsibility. Therefore, it's important to follow up at least once or twice per year to make sure everything has been paid up-to-date.
Do you have to use an escrow account?
It depends. If you have an FHA loan, or a conventional loan with less than 10% down, you'll be required to maintain an escrow account. On standard conventional loans or VA loans, it's up to the lender to decide, although most require (or at least recommend) that all borrowers use an escrow account.
Some lenders will allow borrowers to opt out after certain qualifications are met, such as a record of on-time payments and 20% equity in the home. However, if you choose to opt out, you'll need to prepare for taxes and insurance expenses on your own and make sure they get paid on time.
For this reason, even if you don't have to use an escrow account to pay your taxes and insurance, you should consider using one anyway. It makes paying your large annual or semi-annual bills easier and more convenient, and prevents negative consequences in case you forget or are unable to pay these expenses all at once.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.