How Does Homeowners Insurance Escrow Work?

Whether someone is buying their first home or has purchased many houses, their closing paperwork may include funding an escrow account to cover insurance. Here, we'll explain what it means to have homeowners insurance escrow. Read on to see how having an escrow account benefits homeowners, and how to make changes to escrow when the need arises.

The basics of homeowners insurance escrow

Picture a mortgage payment as a pie, with each piece going toward something different. One part goes toward the principal on a home loan, while another covers the interest on the loan. Still another piece of the pie goes toward an escrow account.

Within the escrow account is a smaller pie, with each segment covering a different expense. One portion pays the annual property taxes on the home, and another pays the insurance premium that protects the homeowner financially if the home is damaged or destroyed. This is called homeowners insurance escrow.

What is a homeowners insurance escrow account?

If a person has a mortgage on a property, the mortgage lender holding that mortgage wants to ensure that the homeowner has the funds to make repairs or rebuild the home if something goes wrong. That's why they insist on homeowners insurance. For a lender, the best way to make sure the premiums are paid on time and coverage never lapses is to collect a portion of the annual premium each month as part of the total mortgage payment. Then, when the premium comes due, the insurance company sends a copy of the bill to the mortgage company. The mortgage company takes the funds out of the homeowners insurance escrow account and makes the payment.

How does homeowners insurance escrow work?

Let's say someone purchases a home for $300,000 and puts 20% down so they don't have to pay private mortgage insurance (PMI). The interest rate is 5%, and their mortgage payment -- including principal and interest -- is $1,288 per month.

Because the lender has a vested interest in making sure all bills are paid, annual property taxes and homeowners insurance are held in escrow until the bills are due. For example, suppose the homeowners insurance premium is $1,200 per year. In that case, the lender collects $100 each month to make sure there's enough in the homeowners insurance escrow account to pay the premium the following year. The mortgage lender also divides the expected property taxes on the home by 12, and tacks that amount onto the regular mortgage payment.

Let's assume property taxes are $3,600 per year. Here's how the mortgage company comes up with the total monthly payment:

The homeowner's total monthly mortgage payment is $1,688, and $1,288 goes toward principal and interest on the loan. The other $400 is placed in an escrow account for the mortgage lender to pull from to pay homeowners insurance and property taxes. If the homeowner pays PMI, those premiums are also added to the total monthly mortgage payment and kept in escrow until it's time to pay the PMI premium.

Mortgage companies review the account once a year to make sure there's enough in escrow to continue covering bills for property taxes and home insurance premiums. Let's say a homeowner's property taxes go up from $3,600 a year to $4,000. If it looks like there might be a shortage, the lender sends the homeowner a letter letting them know their escrow payments will increase, bumping up the homeowner's total monthly payment. By the same token, if a lender sees they've collected more than is needed for the year and it does not appear that homeowners insurance or taxes will increase, they refund the overage to the homeowner.

How do you change homeowners insurance with an escrow account?

The fact that home insurance premiums are paid from an escrow account does not prevent switching to another insurance company. Here's how you can change homeowners insurance in escrow in three easy steps:

Step 1: Gather current declaration page

An insurance declaration page lists information such as coverages and limits. This is important because anytime a homeowner shops for new coverage, they want to compare apples to apples. In other words, they want coverage at least as good as the coverage they're replacing. If they can land coverage as good as (or better) than their current coverage for a lower price, it's a win. However, buying a new policy simply because it's cheaper may leave a homeowner with too little coverage and vulnerable to financial loss. The amount of home insurance needs to -- at minimum -- cover a homeowner's potential losses.

Step 2: Purchase a new policy

It's essential to buy a new policy before canceling the old one. That way, there's no gap in coverage. If there is an established escrow account with the homeowner's mortgage company, the homeowner typically submits the name of their mortgage company to the new insurance company, and the new company bills the lender for the policy.

Step 3: Cancel the old policy

Once the new policy is in place, the homeowner should call the old insurer to cancel the policy. They should also mention when the new coverage began. If there's any unused premium on the old policy, the homeowner receives a prorated refund based on the date the new policy started.

If there's not enough in the homeowner's escrow account to cover the new premium, the lender usually covers the difference. The lender then adjusts the amount of escrow due each month to collect enough to make up the difference.

Do I have to pay homeowners insurance through escrow?

If there's no mortgage on a home, the homeowner pays taxes and insurance on their own. If there is a mortgage, whether or not a lender lets the homeowner pay these expenses on their own depends on the lender and type of loan. For example, an FHA loan must have an escrow account, and homeowners insurance is always paid from that escrow account.

Some lenders let conventional loan borrowers waive an escrow account if they've put at least 20% down on the property. They may, however, require the homeowner to pay an escrow waiver fee. If they do so, the homeowner is responsible for making all tax and insurance payments when the premiums are due.

Is it better to have an escrow account or not?

It does not cost anything to have an escrow account, but there are several benefits. They include:

• The homeowner never has to worry about when taxes or home insurance premiums are due, because their mortgage servicer is responsible for paying those bills.
• An escrow account ensures that enough is set aside each month to cover lump-sum expenses.
• If there's not enough in escrow to cover the cost of homeowners insurance, the mortgage company pays the shortage and factors it in when they review the account for the following year.

The answer to the question, "is homeowners insurance included in escrow" is yes, but the total amount collected upfront varies by state. Home buyers can count on paying at least 15 months' worth of insurance premiums when they close on a house. 12 months of that goes toward prepaying one year of homeowners insurance coverage, and the remaining three months are used as a cushion of sorts. Funds to cover expenses like property taxes and PMI are added to those held for homeowners insurance.

Understanding how escrow works helps a home buyer compare loan offers, ultimately leading them to the mortgage lender they want to work with.