What is Escrow?

If you are a new home buyer, you probably have heard the word escrow, but you may not know exactly what it means. To be fair, you have been exposed to what may seem like a whole new language during your search for a home, one that is filled with real estate and mortgage jargon and confusing new acronyms.

If you feel like you need an interpreter, you are probably not alone. But escrow is easy to understand and navigate once it is defined for you. It is a sign you are near the finish line to homeownership, because once you sign on the dotted line, you are entering into “escrow”.

What happens in escrow

When you have a mortgage, the lender will usually require there be money set aside in an escrow account that will cover the year’s property taxes and homeowners’ insurance for your new home.

Escrow is set up and managed like this:

• At closing, the buyers make an initial deposit toward escrow. Then, payments go into the account every month; these payments are typically added into your monthly mortgage payment.
• The funds you hand over for escrow are held by a neutral third party, called an escrow agent, that works for both the lender and the borrower. The escrow agent’s responsibility is to release the money as your taxes and insurance premiums come due, essentially ensuring that these bills get paid.

Why is this required? If taxes and insurance were left to the homeowner to pay separately from the mortgage, it is possible they could be ignored. Lenders, of course, do not want that scenario.

Escrow payments prevent homeowners from defaulting on property taxes, which could result in a lien on the property. It also prevents lapses in insurance coverage, which, if the house were damaged or destroyed, would leave the lender with no way to recover their investment.

Benefits to the buyer

Escrow is beneficial to new homeowners too, because it enforces their budget and spreads insurance and tax expenses evenly over 12 monthly payments. Budgeting can be one of the greatest challenges of homeownership, and since escrow costs are factored into your monthly mortgage, it breaks down your insurance and tax costs into a manageable amount so you don’t get hit with one large bill.

What if insurance or taxes go up?

Escrow is usually set up with a small built-in cushion, which will cover you if the insurance premium goes up slightly. Since taxes and insurance costs can change slightly from year to year, your lender will adjust the escrow payments annually to maintain the proper cushion. It is worth noting that federal law prohibits lenders from requiring more than two months of expenses in escrow.

Ask your real estate agent or lender about your escrow account or the calculations used to determine your monthly payments if you have any questions. Fully understanding escrow is helpful since this process removes the worry of paying your property taxes and insurance on time, and it will make your monthly budget easier to manage.