Confused about escrow? A lot of first-time homebuyers are (if this clip from Portlandia is any indication). But we’re here to tell you that the biggest misconception about escrow might just be that it’s complicated! In fact, the basic idea is very simple, and most homeowners find that an escrow account makes budgeting easier.
So what is escrow?
Broadly speaking, it’s the use of a trusted “middle man” who handles money or other assets being transferred between two parties, making sure that the terms of the deal are met by both sides. It’s used in business all the time to make sure neither side gets cheated. Pretty straightforward, right?
We’ll explain more below, but in the context of homeownership, escrow comes up twice (which might be one reason for the confusion). Those two instances are:
During the process of closing on your home, to hold “earnest money”
Then as a long-term account that you pay property taxes and insurance into each month, as part of your mortgage payment
Here are answers to the 10 escrow questions that seem to come up the most. Remember that although federal law governs certain aspects of escrow, states and banks are allowed to do some things their own way. So if you’re ever uncertain about an escrow issue, it’s a good idea to contact a local homeownership advisor.
1. What does it mean to be “in escrow”?
When you’re in the process of buying a home, you’re “in escrow” between the time that your offer — with its cash deposit — is accepted and the day that you close and take ownership. That’s usually at least 30 days.
The deposit, often called “earnest money” because it shows that you’re serious, is held “in escrow” — the seller doesn’t get the money until you come to a final agreement on the sale. Then it’s applied to the purchase price.
Depending on where you live, the middle man at this stage might be an individual escrow agent, an attorney, or a title company.
2. What is an escrow account?
Most homeowners have a long-term escrow account, established at closing. The middle man is your loan servicer, and the account is used to collect and hold the portion of your monthly mortgage payment that goes toward property taxes, mortgage insurance, and sometimes homeowners insurance (not all lenders require that homeowners insurance payments be escrowed). When the expenses come due, the servicer pays them for you from the escrow account.
It’s very much like a savings account, but only your loan servicer can make withdrawals.
3. Do I have to set up escrow myself?
No. Not during the sale, and not for the long term at closing. That’s one of the things that a title agent, attorney, or servicer is getting paid to do.
4. How much goes into my escrow account at closing?
As part of the closing costs, lenders often ask buyers to put in two months of estimated property taxes, mortgage insurance payments, and homeowners insurance payments. They like a cushion.
Sometimes you have to pay the entire first year of homeowners insurance up front and immediately start making escrow payments for next year’s bill.
5. Is an escrow account required?
Almost always, because it protects the lender’s investment.
If you were to fall behind on your property taxes, you could end up with a lien on your home — and eventually lose it. As you can imagine, lenders don’t like it when someone else has a claim on your (their) property. And if your homeowners insurance lapsed and your home was seriously damaged, again, the lender’s investment would be in jeopardy.
But an escrow account offers two big pluses for you too:
You’re automatically putting money away for these expenses each month instead of having to budget for a few big payments
Someone else is managing those tax and insurance bills for you
6. Is there any advantage to not having an escrow account?
Sometimes you are allowed to waive the escrow account, for example if you have 20 percent in equity. But because this increases the lender’s risk, there might be a fee for doing so, in the form of a higher interest rate for the life of the loan. Ouch.
If your income varies — maybe you’re self-employed or work on commission — you might find it easier to put tax and insurance money aside in big chunks during good months, instead of every single month. Other than that, some homeowners just prefer to have total control over their money.
Whatever the case, if you want to go without an escrow account, you have to be really good at saving and really good at keeping track of your bills.
7. Can I earn interest on my escrow account?
Probably not. Most states don’t require lenders to pay interest on escrow accounts. If you’re not required to have one, you could earn some interest on the money by keeping it in a regular savings account. But for most people, the annual interest probably wouldn’t even cover a decent dinner for two.
Here are the 15 states that do require lenders to pay interest on escrow accounts: Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont, and Wisconsin. Even in these states, there can be exceptions for legal reasons.
8. Can my escrow payments increase?
Yes. The most common reason for a bump in your escrow account payments is a property tax increase. The tax rate can go up, and so can the assessed value of your property. Your homeowners insurance premium can go up too, but probably with much less impact.
Your escrow payments can go down too. Your tax rate or the assessed value of your home could drop. And if you’re paying mortgage insurance, you’re probably going to get rid of it someday.
Escrow payments are usually analyzed once a year. Since the amount going into escrow is an estimate, sometimes there’s an adjustment, and you get a little back or owe a little extra.
9. What if there’s a mistake in my escrow account?
It might not sound fair, but even when your servicer is handling your property tax and insurance payments, you’re the one responsible for full, on-time payment. On rare occasions, a mistake can leave an escrow account way short on what a homeowner owes.
Here are a few things to keep an eye on:
At closing, watch for math errors and confirm that the right tax rate is being used to calculate your property taxes
Make sure you understand how property taxes work in your area; your local government’s website should have rates and contact info for the assessor’s office
Pay attention to your tax and insurance bills and due dates, even though you’re not paying the bills directly
Your mortgage statement shows both the balance of your escrow account and how much of your current mortgage payment is going into it; check it to make sure you’re on track to cover your bills and that any payments due went out
10. Are my escrowed property taxes deductible?
A tax-time plus for homeowners is that property taxes are deductible, within limits (on Schedule A). But it’s easy to make the mistake of deducting the amount that went into your escrow account instead of the amount that was actually paid out.
Although a portion of every mortgage payment goes into your escrow account for property taxes, your loan servicer doesn’t pay the taxes on your behalf until the bills come due. That usually happens two or four times a year. You’ll find the amount that was paid out on the annual escrow analysis provided by your servicer.