What is mortgage escrow?

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When you’re using a mortgage to buy a home, there’s a good chance your lender will require something 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, generally an account, held by a neutral third party on behalf of two parties engaged in a transaction. With an escrow account, the funds are held or managed by a middleman until the transaction is complete or a contract is fulfilled.

Though escrow accounts are commonly used in real estate, they also can be used for any other transactions that require an agreement between a buyer and seller, or require time to inspect what’s being purchased before payment is made.

How does mortgage escrow work?

Mortgage escrow accounts are special holding accounts for your property tax payments and homeowners insurance premiums. Typically, you don’t pay these bills from this account, or even deposit money for these bills into it. Instead, your mortgage lender will collect these payments on a monthly basis as part of your mortgage payment, hold them in the account, then pay the 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?

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 with an FHA loan or USDA loan, but not with a VA loan.

Your first encounter with an escrow account, however, will likely be when you deposit earnest money to show the seller you’re serious about purchasing their property. The amount deposited will vary, but 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 your earnest money back if you simply change your mind about buying the property.

What is escrow analysis?

Since property taxes and insurance premiums can change over time, your lender will conduct a yearly review, called an escrow analysis, to ensure that there are enough funds in your escrow account. The lender will analyze the amount you’ll need to have in your account over the next year, breaking it down by month. From there, your lender will project if you’ll have a shortage or an overage. (In reality, rising property taxes and insurance mean that escrow accounts rarely have an overage.) You’ll be informed of any changes to your account in a statement after the analysis.

What is an escrow cushion? 

An escrow cushion is an extra amount above your mortgage payments that your lender or 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 lender or servicer is required to refund that money, or you can put it toward the loan principal on your mortgage.

Escrow fraud and scams

Keeping informed about your escrow account is essential, and not just from a budget perspective. Due to the often large amount of money held in escrow, these accounts have become targets for scammers.

The types of scams vary, but one common scheme is duplicating your lender’s or servicer’s website or email communications in an attempt to get your login credentials or have you wire funds to a fraudster. Some scams even set up official-sounding phone numbers as another way to build trust and get you to reveal your login information. Always carefully review any communications relating to your escrow account, and alert your lender or servicer if you suspect fraudulent activity.

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