If you’re using a mortgage to buy a home, your lender will most likely require what’s called an escrow account. Here’s what escrow means and what you need to know about this important part of the mortgage process.
What is mortgage escrow?
“Escrow” refers to a financial instrument, usually an account held by a neutral third party on behalf of two parties to a transaction. With an escrow account, funds are held or managed by a third party until a transaction is completed or a contract is performed.
How does hosting work?
In addition to deposited funds, an escrow account is typically used to hold funds for advances and transaction fees, seller’s credit notes, and other funds that are part of a transaction.
After closing is complete, the trustee distributes all funds as detailed in the estate deed and mortgage deed. These payments include Realtor commissions, loan origination, title and insurance premiums, HOA fees, purchase financing for mortgages, and all other closing costs as detailed in the final closing disclosure.
The trustee carefully follows the details of the real estate contract and your lender’s written instructions to ensure that all funds are used where they are needed.
Types of Escrow Accounts
Escrow accounts are common in real estate, as well as in other business transactions.
Two types of escrow accounts are commonly used in the real estate process.
As mentioned above, the first type of escrow account is used to manage transactions when you buy a home.
The second type of escrow is called a collateralized escrow account.
Home Buyers Escrow Account
Your first exposure to an escrow account will most likely be after the seller accepts your offer on a home. As part of signing the sale and purchase agreement, you will need to pay a deposit to show the seller that you are serious about buying the property.
The amount deposited varies, but is usually 1% to 2% of the purchase price. (In a competitive market, some buyers pay more for such escrow deposits to make their offering more attractive.)
If the inspection reveals major issues with the home or the appraisal falls short of the agreed selling price and the transaction is successful, you can get your deposit back. You may not get back the money you earned just by changing your mind about buying a property.
Homeowner Escrow Account
Once the house is yours, you may come across different types of escrow. For homeowners, a mortgage escrow account is a special repository for your homeowners insurance premiums, mortgage insurance payments, and property tax payments.
You usually don’t pay these bills directly from the account, or even save money for them. Instead, your mortgage lender collects these payments each month as part of your mortgage payment, holds them in an account, and then automatically pays the bills on your behalf. By escrowing your insurance and taxes, your lender can ensure those bills are paid on time and avoid penalties, such as late fees or potential liens on your property.
The amount in the account may change over time because insurance premiums and property tax returns fluctuate. If there is a shortfall, your lender will top up the payment (and then eventually increase your monthly mortgage payment to make up the difference). The lender will send you an annual trust analysis to determine whether your accounts are in the deficit or in excess and how to adjust your monthly payments accordingly.
Setting up such an escrow account typically requires two to three months’ upfront payment of insurance premiums and property taxes upon closing.
Who manages the escrow account?
During the home buying process, buyers and sellers often use a title company or bank as a trustee to manage the down payment.
Once you become a homeowner, your mortgage lender typically manages the escrow account. Your lender will collect your mortgage payment and place a portion in escrow to cover insurance and taxes.
However, there is no requirement that the lender must manage the escrow account. The account can be managed by any trusted third party willing to handle the management of funds. Most mortgage servicers do not allow individuals to control their own escrow account or withdraw funds directly from the account.