A mortgage escrow account is an integral part of the financial picture for most homebuyers. Some homebuyers are required by their mortgage lender to have an escrow account; others may opt-in to one through their mortgage servicer.
What is a mortgage escrow account?
A mortgage escrow account is typically used in two ways: to pay a homeowner’s property taxes and homeowners insurance premiums; or to hold an earnest money deposit when the homeowner first purchases the home.
Instead of scheduling payments and paying insurance and tax bills separately with a checking account, the money for these payments is collected by the mortgage lender or servicer through installments as part of the homeowner’s mortgage payment. The lender or servicer holds these funds in an escrow account and pays these bills as they are due on the homeowner’s behalf.
The key difference between an escrow account and any other financial account you might have: You don’t manage an escrow account yourself. That’s because “escrow” is facilitated by a third party — in this case, your lender or servicer.
If you’re obtaining a conventional mortgage, an escrow account likely won’t be optional if you’re making a down payment of less than 20 percent. FHA loans and USDA loans require escrow accounts, but VA loans do not.
Pros of an escrow account
Having your mortgage lender or servicer hold your property tax and homeowners insurance payments in escrow ensures that those bills are paid on time, automatically. In turn, you avoid penalties such as late fees or potential liens against your home.
You’re covered when there are shortfalls
Your homeowners insurance premiums and property tax assessments can fluctuate over time. For example, if your escrow account happens to be short due to your property tax bill increasing, your servicer will typically cover the difference temporarily. To make up for it, your servicer will eventually increase your monthly mortgage payment.
The exact amount needed for escrow is added to your monthly mortgage payment for you, so you’ll know what to expect the majority of the time. If the escrow component of your monthly mortgage payment needs to increase, you’ll get a notice from your lender or servicer in writing. Plus, your lender or servicer is required to send you an annual escrow statement that shows the amounts you’ve paid (and the drawdowns) along with any overages or shortages.
“Escrow accounts make life a lot easier for the majority of homeowners that want to add predictability to their monthly expenses, rather than getting whacked twice a year with big insurance and property tax bills,” says Greg McBride, CFA, Bankrate’s chief financial analyst.
Potentially lower mortgage costs
Depending on your mortgage lender, you may be able to get a discount on your interest rate or closing costs just by having an escrow account.
Cons of an escrow account
Your mortgage lender or servicer is allowed to collect the amount of your homeowners insurance and property tax payments, plus a cushion, month in and month out, in escrow. While it’s nice to not have to think about making these payments, this pro can be a con for savers who may be able to put the funds to better use.
You might miss out on short-term investment opportunities
Likewise, the money that could end up as an overage in an escrow account could be used for short-term investments. Earning interest on such investments may make more financial sense for you, instead of allowing a bank or lender to reap the gains.
Digital tools and attractive CD rates can help you invest your money outside of escrow and earn a better return for the long term, notes Henry Yoshida, CFP, founder and CEO of Rocket Dollar, a platform based in Austin, Texas, that enables users to invest funds from tax-advantaged retirement accounts.
If you’re considering this route, it’s best to examine current interest rates and your budget.
“With interest rates where they are, there is limited opportunity cost from forgoing interest earnings on money that is instead being escrowed by the loan servicer throughout the year,” McBride says.
A potentially large upfront payment
Often, setting up an escrow account requires a homebuyer to deposit an amount equal to two to three months’ worth of property taxes and insurance premiums. These are sometimes called “prepaids,” and can significantly add to your mortgage closing costs.
Can be tough to get rid of
Once you have an escrow account with your lender or servicer, it can be difficult to remove later if you change your mind.
Can be a target for scammers
The large sums parked in an escrow account make it an attractive target for fraudsters. Common mortgage escrow fraud schemes include cyber thieves setting up fake websites that look similar to the servicer you’re working with, or spoof email addresses to try to get your personal information. Some sophisticated scammers even set up fake phone lines in an attempt to build trust. Under these false pretenses, fraudsters might try to persuade you to wire them money.
Higher monthly payments
Because you’ll be paying for insurance and taxes with your monthly mortgage payment, you’ll have a higher payment. Of course, you have to pay for insurance and taxes inevitably, so they aren’t an additional cost, but having them in your monthly payment could leave less room in your budget month to month.
Possibility of incorrect estimates
The amount that needs to be tucked away in your escrow account hinges on your insurance premiums and property taxes, which can vary year to year. Generally, the previous year’s bills are used to figure out how much you’ll need, but incorrect estimates can happen if, for example, the assessed value of your home has increased.
Should you use an escrow account?
Depending on the type of loan you have, you might not have the option to forgo an escrow account. If you do have a choice, look at the pros and cons. There are viable reasons to have an escrow account: It can be an easy, hassle-free way to make payments for your mortgage, homeowners insurance and property taxes, and the cushion can help cover shortfalls. Although you’ll have a higher monthly mortgage payment, consider what it’d take for you to make those payments on your own twice a year: You’d need to be diligent about setting aside the funds, including extra for any unforeseen increases in premiums or taxes.
A mortgage escrow account may not be required, depending on the specifics of your loan. Many mortgage lenders allow homeowners to make property tax payments directly to the county assessor and homeowners insurance premium payments to their insurer, but in order to have this option, they generally require a loan-to-value (LTV) ratio below 80 percent. In other words, you need to have made a down payment of at least 20 percent on your home.
Ultimately, an escrow account is a common financial tool lenders and servicers use, helping to ensure your obligations as a homeowner are met without much effort on your part (aside from making your mortgage payment). However, if escrow isn’t required, you might want to explore alternative uses for those funds.