Mortgage Escrow: What Is It, and How Does It Work?

Photo to accompany story about mortgage escrow accounts. Adobe Stock
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The cost of owning a home doesn’t end with your monthly mortgage payment. 

Having to pay for annual expenses like property taxes and homeowners insurance can throw a wrench in your finances if you aren’t properly budgeting for them.

But a mortgage escrow account can help by breaking those expenses down into manageable, monthly payments.

Last year, Americans residing in single-family homes paid an average of over $3,500 in property taxes and at least $1,800 for homeowners insurance. That’s a lot to pay all at once. 

While you can create a budget to save for these costs, a common way to budget for these expenses is with a mortgage escrow account. 

A mortgage escrow account is basically a savings account for your property taxes and homeowners insurance, says Danielle O’Brien, owner and real estate broker with Massachusetts-based Parkway Real Estate. Your mortgage lender will calculate the annual cost of your property taxes and homeowners insurance premiums and divide that number by 12. That amount is part of your monthly mortgage payment and automatically deposited into your escrow account. Then, the funds will later be used to cover those expenses when they come due.

How Do Mortgage Escrow Accounts Work?

An escrow account is a financial account where a neutral third party holds money or other assets for a specific purpose. You’ll usually run into escrow accounts on two occasions: when you’re purchasing a property and when you’re getting a mortgage. 

When an offer is accepted during a real estate transaction, the earnest money, or good-faith money deposit made by the buyer, is held in an escrow account until the sale is completed. In this situation, the listing real estate agent is typically the third party who manages the escrow account for the buyer and seller.

When you take out a mortgage, the lender will usually establish an escrow account, which is sometimes  called an impound account. The money deposited into this account will be used to pay for your homeowners insurance, property taxes, and private mortgage insurance, if it applies to your loan. 

While there are typically no fees to maintain a mortgage escrow account, you’ll be required to fund it with an initial deposit at closing and with ongoing monthly deposits, which are part of your mortgage payments. Your monthly mortgage escrow payment is one twelfth of the combined annual cost of your property taxes and insurance. The initial escrow deposit made at closing will be anywhere from two to three months of escrow payments depending on the timing of when you close, says James Sahnger, loan officer with Florida-based C2 Financial Corporation.

There’s an escrow analysis done at the end of every year, Sahnger continues. This analysis looks at any changes to your property taxes or homeowners insurance and adjusts your monthly escrow payments accordingly. 

When Do You Need an Escrow Account?

Some lenders will allow you to waive escrow with as little as 10% as a down payment, while others will require you to put 20% down before they’ll waive the escrow requirement, Sahnger says. Certain types of mortgages require escrow accounts regardless of the size of the down payment, like Federal Housing Authority (FHA) loans. So sometimes choosing whether you have an escrow account isn’t an option.

But even if you can have the escrow requirement waived for your mortgage, you may not want to. If your property taxes or homeowners insurance are exceptionally high, it can be tougher to budget for these bills. An escrow account makes it much easier to pay for property taxes and homeowners insurance because those costs are automatically broken down for you into equal monthly payments. 

Having your property tax and homeowners insurance payments held in escrow also makes it easier to avoid late fees and may even save you money. Some states offer a discount if you pay your property taxes early. A lender will always pay taxes at the earliest date to get the discount, Sahnger says. For example, in Florida property taxes aren’t due until March, but if you pay in November there’s a 4% discount off of the annual property tax bill, he says. 

Are There Downsides to Having a Mortgage Escrow Account?

Some people may waive escrow because they’re more confident managing their finances on their own, Sahnger says. There’s no specific advantage to removing escrow, unless you feel the interest you could earn on the money that would be held in the escrow account will outweigh paying escrow on a monthly basis, he says. But Sahnger believes that with interest rates as low as they are right now, it’s hard to say that’s the case. Also, some borrowers are required to be paid interest for funds kept in escrow in some states.

It wouldn’t be smart for a homebuyer to opt out of a mortgage escrow account, O’Brien says. Not having a mortgage escrow could put you in a high-risk situation where you could default on property taxes or have a lapse in your homeowners insurance coverage if you can’t afford those payments. “When I’m talking to buyers about the fact that there will be a principal and interest payment plus a payment to escrow, I emphasize how important an escrow account is,” she says.