What is an escrow account? Your ultimate guide

Buying a home comes with many new financial responsibilities, including property taxes and homeowners insurance. Escrow accounts are a way for your lender to help you manage these expenses by including them in your mortgage payment.

Note: Another type of escrow account may be used during the homebuying process to hold a buyer’s earnest money deposit. That type of escrow account is not related to the one used for taxes and insurance, which will be covered in this article.

When you purchase or refinance a home, your lender will establish an escrow account to pay for property taxes and homeowners insurance, as well as other expenses like flood insurance and private mortgage insurance (PMI).

Every time you make a mortgage payment, part of it will go into the escrow account. When your tax and insurance bills are due, your lender pays them on your behalf using the funds in your account.

Escrow accounts are not used for homeowners association (HOA) fees or for supplemental tax bills. These one-time tax payments are usually paid directly by the homeowner.

Using an escrow account to manage your taxes and insurance payments can offer important benefits.

• One mortgage payment covers multiple expenses. You don’t have to save or pay for your taxes or insurance separately because your lender does it on your behalf, which means fewer bills you need to track.
• Large expenses get broken down into smaller monthly payments. Instead of getting hit with large insurance and tax bills that may come to thousands of dollars each year, the cost is spread evenly across your monthly mortgage payments.
• Your payments stay up to date so you stay protected. Falling behind on taxes or insurance can lead to financial and legal consequences that no homeowner wants to deal with. Having an escrow account can help ensure you stay on top of these expenses with the help of your lender.

Each year, your lender will perform what is called an escrow analysis, which helps ensure there will be enough funds in the account to cover future tax and insurance payments. This process involves reviewing the account activity from the previous 12 months and making projections for the upcoming 12 months. 

Your lender will provide these details in your annual escrow analysis statement. Your statement will also let you know if your monthly escrow payments will change for the coming year and whether there is a shortage or surplus in your escrow account.

A shortage may occur in your escrow account if tax and insurance bills were higher than projected, so your lender didn’t collect enough each month to cover the actual amount. If you have a shortage, your statement will indicate whether you have the option to make up the difference with a one-time payment, or to have part of it added to each monthly payment over the next year.

A surplus usually occurs for the opposite reason: your tax and insurance bills were lower than projected, so your lender collected more each month than was needed to cover the actual amount. If you have a surplus, your lender will usually send a refund with your escrow statement. If the overage is below a certain amount (typically $50), it will be left in your account.

Not every mortgage requires an escrow account. Standards for requiring escrow can vary between lenders and usually depend on factors like down payment amount or loan-to-value ratio, as well as loan type. For example, Federal Housing Administration (FHA) loans always require escrow accounts. Talk to your lender before closing about escrow requirements, and if it’s possible to waive escrow if you think that might be a better option for you.