Escrow Process Explained

What is an escrow account?

When you close on a mortgage, your lender may set up a mortgage escrow account where part of your monthly loan payment is deposited to cover some of the costs associated with home ownership. The costs may include but are not limited to real estate taxes, insurance premiums and private mortgage insurance. This practice ensures that payments are made on time to third parties, such as county taxing authorities and insurance companies.

How does an escrow account work?

To set up your mortgage escrow account, the lender will calculate your annual tax and insurance payments, divide the amount by 12 and add the result to your monthly mortgage statement. Each month, the lender deposits the escrow portion of your mortgage payment into the account and pays your insurance premiums and real estate taxes when they are due. Your lender may require an “escrow cushion,” as allowed by state law, to cover unanticipated costs, such as a tax increase. If the estimated amounts are higher than actually needed, the overage balances will be refunded or credited to you.

Can you avoid escrow?

Some lenders will allow you to pay the taxes and insurance on your own, making you responsible for saving the funds and paying on time. Banks generally use the loan-to-value (LTV) ratio to determine if your mortgage loan will require an escrow account, and borrowers whose mortgage amount represents 80% or less of the home’s value typically may avoid escrow if they so choose. However, if you have less than 20% equity as a buyer, you are required to have an escrow account. Loans guaranteed by the Federal Housing Administration (FHA) and Veterans Affairs (VA) also require that you have an escrow account for these expenses.

Should you set up an escrow bank account?

The answer to this question depends on whether or not you are disciplined about your finances and able to set aside the funds needed for property taxes and insurance payments. If you’re not a good saver or are tempted to spend extra cash perceived as “left over,” then you are probably better off having your lender handle these payments, especially since failure to pay can result in penalty charges, a lapse in insurance coverage or even a lien on your home. If you are disciplined at saving, you may prefer to control the process since tax payments usually are due only once or twice a year.

Who Manages the Escrow Account?

The escrow bank account is managed by your lender. It’s the bank or mortgage company’s responsibility to pay your bills on time. Your lender is liable for penalties should there be a missed or late payment.