How Does Escrow in a Mortgage Work?

Your mortgage payment is made of many parts, including the principle and the interest, which in general are commonly understood by more borrowers.

But what about the property tax and home insurance? Why are these a part of your mortgage calculation? For that matter, how is this money delivered to the right people?

Your property taxes and insurance are often handled by the lender through a process known as mortgage escrow.

Understanding “Escrow” in General

Before moving into mortgage escrow, it helps to take a step back and learn about escrow in general. (After all, if you don’t know what “escrow” means, it’s hard to know what “mortgage escrow” means!)

Escrow is simply the act of placing money in a third-party account; the third party agrees to hold the money and release it once certain conditions are met by the two pother parties. It can be applied to numerous industries (in theory all industries), but is commonly used in real estate, banking, business mergers, legal services, intellectual property, internet transactions, and services.

Escrow in Action: A 21st-Century Example

Many online freelance workers and their clients use an escrow system. A graphics designer may agree to complete a logo for $300 on behalf of a plumber. (Or law office or retailer or whatever.) The plumber places the $300 in an escrow account held by a third party who, for a nominal fee, agrees to hold the money and release it once all conditions of the project are met. By placing the money in escrow, the plumber shows he has the cash to pay for the project and is serious about paying the designer. The designer has higher assurance that she will get paid when the work is done.

What is Mortgage Escrow and How Does it Work?

An escrow account for your mortgage is essentially a savings account that is managed by your mortgage servicer that is used to cover property taxes and insurance. It’s really that simple: the bank or mortgage provider holds an account in escrow and uses the money to pay taxes and insurance. (It can be used to pay other components, but this is usually all.)

The lender has a vested interest in making sure the taxes and insurance are paid. If they hold a mortgage on a property, that physical property acts as collateral against the loan; if the borrower can’t repay, the bank can foreclose on the property. But if taxes go unpaid, the city or county could seize the property, which means the bank no longer has their risk-reducing collateral. Likewise, if insurance goes unpaid, the home could be completely destroyed and the borrower would have no way of repaying the bank.

For these reasons, banks and lenders are extremely meticulous about ensuring taxes and insurance are paid promptly. It’s so important that they often take over the process of paying these expenses. To fund the payments, they add an additional fee to the loan payment, then take this portion of the payment and deposit it into an escrow account.

Note: Post-Purchase Mortgage Escrow, Not Escrow During Purchase

In this case we are not talking about the escrow that is used during the home-purchase process. When buying a home, you will write an “earnest money” check that is kept in escrow. In this case, the money is held by a third party and released when the sale is complete. This gives reassurance to the seller that you won’t back out of the agreement, at least not without a financial penalty. With this escrow, the seller can confidently remove their property from the open market.

When Will an Escrow Account be Required?

Mortgage escrow is common, but it’s not always required. In general, there are certain situations when using this process are more common, and it’s entirely possible to have a mortgage loan with no escrow account whatsoever. In this case, you would be paying the taxes and insurance on your own.

Young couple meeting with lending agent.
Many people will have mortgage escrow as part of their monthly billing.

The type of loan you have will impact whether or not you have escrow. Many government-backed mortgages, such as loans insured by the FHA and USDA, will require an escrow account. So if you go with an FHA loan, or if you live in a rural or suburban location and use a USDA loan, you can expect an escrow payment on your mortgage.

Escrows may not be necessary, but they are often a good practice. If mortgage escrow is not in place, you will be solely responsible for paying the property taxes and insurance on your own, so you will need to plan the budgeting for these expenses. If these payments are wrapped into an escrow account, you can simply pay the mortgage and not worry about the additional bills. (Yes, the cost is essentially the same, but everything is encompassed in one payment.)

Also, with mortgage escrow you pay the taxes and insurance (through the escrow account) throughout the year with monthly payments. If you were to pay on your own, you would need a large lump sum, which might take your finances by surprise.

Establishing the Totals: An Escrow Analysis

The lender or bank will need to establish the amount to be charged every month. This is done through a process called an escrow analysis. Basically, they look at the taxing authority, the insurance company, previous taxes and bills on the property, and a few other factors to determine exactly how much should be placed in the escrow account every month. This is based on a general estimate, however, so the cost can fluctuate.

If the estimate is high (you are paying more than necessary into the escrow account), you will receive money back as a refund. But if the estimate is low, you will have to pay the shortage, either by paying all right away or spreading the costs into your mortgage payment.

Through the use of escrow, lenders can make mortgages more convenient while providing additional protection for their loans. In the end, this protection can mean more available loans for potential borrowers. So, in a way, you could argue that mortgage escrow helps increase the rate of homeownership!

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