What is an Escrow Account?

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escrow accountWhen something is in escrow, it means it is held by a third party, and an escrow account is one set up to hold money, documents and other items related to a transaction. Escrow accounts are most common in real estate and they are used for a couple of different purposes.

ESCROW ACCOUNT INFORMATION

At Sale and Closing

When you agree to buy a home, you usually are asked to put down a “good faith” deposit that shows you are serious about going through with the sale. This money will be held in an escrow account until the transaction closes. Also, any funds you have to contribute to the closing, such as real estate taxes, also will be held in escrow until the sale closes and all aspects are settled.

Mortgage Escrow

The type of escrow account with which most people are familiar is the escrow account related to your mortgage. Lenders prefer — and some require — an escrow account into which you pay a monthly amount toward your real estate taxes, homeowners insurance and mortgage insurance if you have it. A lender can legally require you to have an escrow account if you have less than 80 percent equity in your home. If your equity is 80% or more, then you can opt out of escrow. It is best to opt out when you get the loan, because it’s very difficult to do so later. However, your lender can charge a waiver fee or bump up your interest rate if you decide to opt out.

How Does It Work?

When you have an escrow account, your lender divides your home insurance premium, real estate tax bill and mortgage insurance premium by 12 and then adds those totals to your mortgage principal and interest payment so that you pay all those amounts in one payment each month. Then your lender is responsible for paying your taxes and insurance when they are due. Your lender also is responsible for adjusting your payment up or down to account for increases or decreases in your taxes and insurance.

Advantages

There are big advantages to escrow accounts for both lenders and borrowers. For the lender, having an escrow account assures that the house is insured and that taxes are being paid so no liens are filed on the house. For the borrower, it offers the convenience of one monthly payment and not having to budget for big once- or twice-a-year tax payments.

Disadvantages

There really is no disadvantage to the lender of having an escrow account, other than the time and expense needed to administer it. For borrowers, the one big drawback is the potential lost earnings on the money put into escrow. The federal government does not require lenders to pay interest on money put into escrow and only a handful of states do. That means you are missing out on some potential interest and investment returns on the money you put into escrow. However, many people are willing to give that up in exchange for the convenience.

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