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What Is Mortgage Escrow and How Does It Work?

Christy Bieber
By: Christy Bieber

Our Mortgages Expert

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Whether you're a first-time home buyer or a seasoned homeowner, it's important to know that there are many costs of homeownership besides your monthly mortgage principal and interest payment. Two of the biggest are property taxes and insurance. Many mortgage lenders require you to include money for these expenses in your monthly mortgage payment. This is put into a mortgage escrow account to ensure the bills get paid. But what is mortgage escrow exactly?

What does escrow mean?

Escrow is a legal agreement that allows a third party (such as a mortgage lender or an escrow agent) to hold your money for a specific purpose. If you're buying a home, two types of escrow may affect you -- before you buy and after you've bought your home.

When you make an offer on a property, you'll generally have to make a deposit to show you're serious. The money is held in an escrow account. If you complete the purchase, the escrow company delivers it to the seller. If you don't, and you had a lawful reason for walking away from the sale, the escrow company returns it to you. Or if you voided your offer contract, you'll lose it.

After you've borrowed to buy a home, your lender may require that you pay property taxes and insurance over time as part of your mortgage payment. Your lender collects this money and keeps it in a mortgage escrow account until your payments are due.

How do escrow accounts work?

Escrow accounts work very simply. A trusted third party holds money for the benefit of others. This can happen in many situations, including where one person wants to sell a home or other valuable item to another person but the transaction can't be completed immediately.

Mortgage escrow accounts are one of the most common examples of an escrow account. Lenders have an interest in making certain you pay your property taxes and your insurance. That's because your home serves as collateral for the loan and they don't want it destroyed or seized for nonpayment of tax. To ensure you have the money to pay, they add the costs onto your mortgage payment and keep it in escrow until the bill is due.

Generally, when you close on a mortgage loan, you'll have to pay a portion of your property taxes, and insurance. The lender will put this money into escrow immediately. The lender will also determine how much you should be paying each month to cover these costs, and this money will also be put into escrow.

The bills for your taxes and insurance will then be sent directly to your lender and paid from your escrow funds. Each year, lenders evaluate whether you're paying enough into your account. They may increase or decrease the amount -- which would in turn raise or lower your mortgage payments.

Who manages an escrow account?

Mortgage servicers generally manage mortgage escrow accounts used to collect funds for property taxes and insurance. Escrow agents, title agents, or other trusted third parties may also manage escrow accounts. These services will typically hold your earnest money deposit after you've made an offer on a home but before your transaction is completed.

When do you need an escrow account?

You need an escrow account if your mortgage lender requires one, or if you are mandated to have one based on the type of loan you're taking out.

You are required to have an escrow account if you:

For other loan types, lenders have discretion to determine whether to require an escrow account. Many do, or instead charge you a fee to waive escrow.

How much do escrow fees cost?

Escrow companies that hold your home deposit and manage the closing of your property typically charge a small fee. This could be around 1% of the home's sale price. Or sometimes it's a flat fee of $500 to $1,000.

Lenders generally don't charge a fee to manage an escrow account. You will simply make your required insurance and property tax payments into your account. If your taxes and insurance add up to $6,000 per year, this amount will be divided by 12 to determine you must add $500 per month to your mortgage payment to be deposited into your escrow account.

A mortgage calculator can help you to figure out the total costs you're looking at for principal, interest, and escrow payments covering your taxes and insurance.

Can you avoid escrow?

You may be able to avoid escrow if your loan doesn't require it and your lender allows you to waive it. FHA mortgages and mortgage loans where a small down payment is made can't avoid escrow.

To avoid escrow, you generally must be a well-qualified borrower. Some mortgage lenders may charge an added fee to waive escrow. Lenders may also require mortgage escrow when you initially borrow, but allow you to opt out after you meet certain conditions, such as making a set number of on-time payments.

If you're considering avoiding escrow, be aware you'll be responsible for covering your own property taxes and insurance. Make certain you're setting aside an appropriate sum of money to do so.

Still have questions?

Here are some other questions we've answered:

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  • Escrow involves using a third party service to hold money on your behalf and act as an intermediary between you and another party. When you borrow to buy a home and your lender requires mortgage escrow, the lender will collect money as part of your monthly payment to cover taxes and insurance. The money is held in an escrow account, the bills are sent directly to your mortgage lender, and your lender pays the amount due.

  • If you are required to have a mortgage escrow account, your lender will determine the amount you must deposit into escrow when you close on your home. Often, this is enough to cover several months of property taxes and insurance. Your lender will also calculate how much money you should pay each month as part of your mortgage payment to fully cover the bills for property taxes and insurance on your home.

    The money you initially deposit and the monthly payments you make will be deposited into your escrow account. Your property taxes and insurance bills will be sent to your lender, who will use the funds in your account to pay them. Escrow accounts are designed to ensure these bills are covered.

  • Mortgage escrow is required on FHA loans, as well as on VA mortgages and conventional loans when you make a small down payment. In other situations, lenders have the discretion to determine if mortgage escrow is required. It's generally mandatory unless you are a well-qualified borrower, or have met certain conditions such as making a set number of on-time payments.

Our Mortgages Expert