During the home buying process, mortgage lenders may use the term “escrow” from time to time. Lenders can use the word “escrow” in several different contexts. However, they typically refer to escrow as the process where:
- Earnest money, also called a good faith deposit, is sent by the buyer to a neutral third party who holds the funds until the contract is complete.
- An account holds the homeowner’s monthly tax and insurance funds.
There are two types of escrow accounts, both used for different purposes. One escrow account is used during the home buying process, while the other is used throughout the life of the loan.
What Is Mortgage Escrow?
Mortgage escrow accounts are special accounts to hold your property tax payments and homeowners insurance premiums.
A mortgage consists of four different payments. Mortgage lenders calculate these monthly payments using the acronym PITI, which stands for Principal, Interest, Taxes, and Insurance.
- A portion of each monthly mortgage payment goes toward paying the principal, and a portion goes toward paying the interest.
- Homeowners must also pay property tax and homeowner’s insurance. Both payments are usually due annually, but lenders typically build these into monthly mortgage payments and hold them in a mortgage escrow until they are due.
Why Do Lenders Hold These Payments in a Mortgage Escrow?
Lenders tend to hold the tax and insurance fees in a mortgage escrow to ensure the funds are available when they are due. However, if these fees were late, they could result in fines or even liens against the homeowner’s property.
What is a Mortgage Escrow Analysis?
Because taxes and insurance rates can change over time, the escrow account will occasionally experience a shortage or overage.
The lender will perform an escrow analysis every year. Lenders analyze the current rates and compare them to the amount needed in the escrow account. If the account has a shortage or overage, the lender will adjust the following year’s rate. However, taxes and insurance are more likely to rise than fall, so these adjustments usually take the form of a rise in monthly mortgage payments.
Who Manages Mortgage Escrow Accounts?
Depending on where you are in the mortgage process, the escrow account can be managed by different parties. Escrow accounts can be managed by various third parties, such as an escrow company, escrow agent, or mortgage servicer.
The lender is typically the mortgage servicer, but occasionally the lender will sell the loan’s rights to a different mortgage servicer in some situations. Not all providers have the same fees, so homebuyers should always ask their lender about the policy and fees.
When Is a Mortgage Escrow Required?
Most lenders require a mortgage escrow account. These accounts are usually needed when the homebuyer purchases with the following:
However, per the VA Lenders Handbook, the U.S. Department of Veterans Affairs does not require lenders who offer VA loans to establish an escrow account.
Of course, this only relates to the mortgage escrow account. When a homebuyer puts in an offer on a home, lenders typically require earnest money (a good faith deposit) in an escrow account. The earnest money is around 1-2% of the total home price.
What is an Escrow Cushion?
An escrow cushion is an additional amount a lender can collect to cover possible tax or insurance increases. Escrow cushions are allowed by most state and federal laws but are typically limited to a maximum of two monthly escrow payments.
What Escrow Accounts Don’t Cover
While escrow accounts collect homeowner’s insurance and property taxes, they do not cover other home-related expenses. For example, utilities, Homeowner’s Association fees, or supplemental tax bills are separate expenses unrelated to escrow accounts.
Do You Need A Mortgage Escrow Account?
While many homeowners can pay for their annual tax and insurance on their own, it places the burden of responsibility on them to ensure they have the funds and submit payments when they are due. The upside of not having a mortgage escrow account is lower monthly mortgage payments.
However, this is not an option that all lenders promote. Homebuyers need a strong credit history and a 10% down payment (for VA loans) or a 20% down payment (for conventional loans) to opt out of a mortgage escrow account. Mortgage escrow is mandatory for FHA loans.
The Benefits of a Mortgage Escrow
Because taxes and insurance are due annually, a mortgage escrow account makes payments manageable for homeowners.
Instead of paying a large lump sum yearly on a specific date, many people find it easier to fund a mortgage escrow through their monthly mortgage payment and let the third party managing the escrow account make the annual payment.
We specialize in mortgages for first-time homebuyers, conventional home mortgages, refinance loans, reverse mortgages, and FHA, VA, and USDA mortgage options. We’ve worked extensively with cash-out refinancing and help clients to lower their monthly mortgage payments.
Updated on January 27. 2023