Whether it’s your first time buying a home or you’re putting your current home on the market, there are a lot of unfamiliar terms associated with the home-buying process. Escrow is a term you’ll probably encounter that you may not be familiar with, especially if you’ve never purchased a home before.
Understanding what escrow on a mortgage is and how it works will make it easier for you to navigate the home-buying process. It’s not only something that will be part of finalizing the sale of a home, but it’s something you’ll use throughout the life of your mortgage too. Here’s everything you need to know about escrow on a mortgage.
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- Escrow is an account that is maintained by a third party for the purpose of holding money until you finalize purchasing a home.
- Home buyers can use an escrow account as a sign of good faith to show the intention of purchasing a home while protecting themselves in case the sale falls through.
- Escrow accounts are used as an ongoing feature of a mortgage to collect funds for, and pay, property taxes and insurance.
- Some lenders require the use of escrow accounts with mortgages as a way to guarantee the payment of these ongoing costs.
What is escrow?
Escrow is an account that holds money in real estate transactions until the terms of a transaction are complete. It’s also a tool that can be used to manage ongoing costs associated with owning a home, typically homeowners insurance and property taxes.
Putting money in an escrow account allows home buyers to provide a deposit on purchasing a house, signaling their intention to move forward with the transaction. This is often referred to as earnest money and is typically 1% to 3% of the home’s purchase price. It’s a way of protecting buyers if the sale falls through. Once the sale is finalized, earnest money is credited toward the down payment.
Lenders also use escrow accounts as a way to help homeowners manage ongoing expenses, like property taxes and homeowners insurance premiums. A portion of the monthly mortgage payment is allocated toward escrow which allows borrowers to set aside money throughout the year for these expenses. By doing this, lenders protect themselves by reducing the risk that a borrower might miss a payment.
Insurance premiums and property taxes can fluctuate from year to year. A homeowner who is already struggling to pay their mortgage may find it impossible to keep up if there’s an unplanned increase. Escrow accounts make sure homeowners are able to pay all of the necessary expenses associated with owning a home in addition to the monthly mortgage payment.
While escrow accounts can serve different purposes, if you’re in the market to buy a home keep in mind you’ll likely have to maintain one until you pay off your mortgage.
Escrow Account: How does it work?
A third party manages an escrow account to hold funds on behalf of homebuyers and homeowners. During the home buying process, this is typically the title company. When you have a mortgage, the lender is holding the funds for your taxes and insurance in an escrow account.
Mortgage escrow accounts work in a similar fashion for real estate transactions. For buyers, they're a way of letting sellers know that they are serious about purchasing a home without risking their money. If there's an issue and the sale falls through, the homebuyer has protection. For lenders, an escrow account is a way to mitigate risk to ensure borrowers pay obligatory expenses associated with home ownership, like property taxes and insurance payments.
Related: How to get a mortgage
Escrow Account: Who manages i?
Various third parties, such as a mortgage servicer, escrow agent, or escrow companies, can manage escrow accounts. Real estate attorneys and title companies may also handle your account, depending on your position in the home buying process and whether your lender mandates an escrow account.
You might assume that the financial institution that issues your mortgage is the same as a mortgage servicer but that isn’t always the case. Financial institutions can buy and sell loans, implying that your mortgage could end up with a different provider. In the process, identify who manages your loan and escrow account.
There is usually a fee to maintain an escrow account. Buyers and sellers can opt to split the fee down the middle as the transaction processes. Financial institutions can buy and sell loans, implying that your mortgage might end up with a different provider. This can vary between services, with some charging more than others.
One important thing to note about escrow companies is that they aren’t just responsible for holding money. They also maintain important documents related to buying a home. Amidst paperwork, a third party aids the organization in the moving forward process.
Pros and cons of an escrow account
In many cases, a mortgage escrow account is a required part of the homebuying process. It’s not something you’ll be able to avoid. However, it's crucial to consider both the benefits and downsides when purchasing a home.
Pros
- Protection: Provides lenders with protection to reduce risks associated with making mortgage payments.
- Planning for unplanned expenses: A large increase can suddenly make your monthly mortgage payment unaffordable. An escrow account acts as a sinking fund.
- Avoid missing payments: The lender submits the payment on your behalf.
Cons
- Higher mortgage payments: Factoring in escrow can make your mortgage payment higher than you might have originally planned.
- Fees: Third-party assistance benefits you and your lender, but comes with added costs.
What if you don’t want to use an escrow account?
The lender assumes a risk when neglecting to ensure payment of taxes and insurance. Failure to pay could result in government action, property damage, and financial loss for the bank. Hence, in some cases, lenders may mandate maintaining an escrow account in your loan terms. If you can afford a higher down payment and have good credit, you may waive the requirement.
If you don’t want to use an escrow account, these are a couple of alternatives you can consider. One option is to obtain a letter of credit. This essentially signifies that a borrower commits to making payments as obligated. Another is a bank guarantee. Letters of credit and bank guarantees make the bank liable if the borrower can't pay.
Create a sinking fund for major expenses, acting as a de facto escrow account. This allows you to set aside money for your homeowners' insurance premium, property taxes, and any unplanned increases to either. The benefit of doing this is that it’s an account you fully own. Plus, putting this money in a high-yield savings account or certificate of deposit can be a good way to allow your money to grow too.
FAQs
Do I have to use an escrow account for my mortgage?
It depends on the terms of your loan and your servicer. Certain types of mortgages require an escrow account, like FHA loans. If you purchase a house without a full 20% down payment, most lenders will require one too. Depending on the value of the mortgage your lender may also ask you to have one to mitigate risk.
Why does the escrow account cause my monthly payment to change?
Escrow adjusts monthly payments for expenses like property taxes and homeowners insurance. These are expenses that come with owning a home that you won’t be able to avoid. If the rate on either of these increases, your monthly escrow payments can increase as well.
Refinancing your mortgage can also cause your monthly payment to change which would affect the amount allocated for escrow.
What does it mean when money is “in escrow”?
In escrow, a third party holds money or property for a real estate transaction until meeting all conditions and finalizes the sale.
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