What is mortgage escrow?

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When you are using a mortgage to buy a home, there’s a good chance that your lender will require something called an escrow account. While you’ve likely heard the word “escrow” while watching real estate reality TV shows, you still might be wondering: “What is an escrow account?”

First, you’ll need to understand what escrow means. Escrow is a legal concept that refers to financial instruments held by a neutral third party on behalf of two parties who are engaged in a financial transaction. An escrow account basically means that funds are being held or managed by a middleman until the transaction is complete and/or a contract is fulfilled. Though escrow accounts are commonly used in real estate, they also can be used for any other purchases or transactions that require an agreement between buyer and seller, or require time to inspect an item before payment is made.

How does mortgage escrow work?

Mortgage escrow accounts are special holding accounts for your annual property tax bill and homeowners insurance premiums. However, typically you don’t pay these bills separately (or even deposit money for these bills). Instead, your lender will collect these payments on a monthly basis as part of your regular monthly mortgage payment, then will pay these bills automatically on your behalf.

By holding your property tax and homeowners insurance payments in escrow, your lender ensures that these bills are paid on time, avoiding penalties like late fees or potential liens against your property. The amount of money in the account can change over time, because property tax assessments and insurance premiums fluctuate. If there’s ever a shortfall, your lender will still cover the payment (and then eventually increase your monthly mortgage payment to make up that difference.) The lender will send you an escrow analysis annually that identifies whether your account has a shortfall or is overly funded, and how your monthly payment will be adjusted as a result.

Establishing a mortgage escrow account often requires a few months’ worth of property tax payments and premiums upfront at the time of closing.

When do you need an escrow account?

If you’re buying a home, your first encounter with an escrow account will be when you deposit earnest money to show the seller that you’re serious about purchasing their property. The amount deposited will vary (typically it’s 1 percent to 2 percent of the purchase price). (You’ll get your deposit back if an inspection reveals major issues with the home, or the appraisal falls short of the agreed-upon sales price and the deal falls through.) However, you might not get the earnest money back if you simply change your mind about buying the property.

Mortgage escrow accounts — where your property tax and homeowners insurance premiums are paid from — are often required by lenders. Typically, you’ll need an escrow account if your down payment is less than 20 percent. A mortgage escrow account is required if you’re purchasing a home insured by the Federal Housing Administration (FHA).

Escrow analysis

Since property taxes and insurance premiums will fluctuate over time, your lender will conduct a yearly review to ensure that there are enough funds in your escrow account. They’ll analyze the amount you’ll need to have in your account over the next year, breaking it down by month. From here, your lender will project if you’ll have a shortage (your balance falls below the minimum balance) or an overage. They’ll inform you of any changes to your account in a statement after the analysis.

What is an escrow cushion?

The cushion is an extra amount above the total of your yearly payments that the mortgage servicer is allowed to collect and hold. The cushion amount can’t exceed two monthly escrow payments. In some states, a cushion may be limited to a smaller amount.

If your cushion is too large at the time of your yearly escrow analysis, the servicer is required to refund that money or you can put it toward your principal. In reality, rising property taxes and insurance mean that escrow accounts rarely have an overage.

Watch for escrow scams

Keeping informed about your escrow account is essential, and not just from a budget perspective. Due to the often large amounts of money held in escrow, these accounts have become targets for scammers. The types of scams vary from duplicating your servicer’s website (or email communications) in an attempt to get your log-in credentials or wire instructions. Some scams even set up official-sounding phone numbers as another way to build trust (and get you to reveal your log-in information). Always carefully review any communications relating to your escrow account, and alert your servicer if you suspect fraudulent activity.