“Escrow” is a strange word, and one that most people don’t hear every day. Yet if you’re closing on a home or seeking a mortgage from a lender, you’ll likely encounter the terms “escrow” or “impound account” sooner rather than later.
From a mortgage lender’s perspective, to hold funds in escrow means that the lender requires you to deposit certain funds into a special account (also called an impound account) to ensure that the money is available to pay bills such as real estate taxes and insurance.
Not everyone is required to have an escrow account. Banks or lenders sometimes waive escrow if the buyer deposits 20 percent or more on a real estate purchase as a down payment. Typically they view such buyers as good risks because these buyers have saved a considerable chunk of money, and therefore the lenders have more confidence in such buyers to pay their bills over time.
In the case of a Real Estate transaction, escrow may also apply prior to the closing of your home purchase. Many mortgage companies and state regulations require an escrow account that will contain funds (namely your earnest money) to apply to the closing of your real estate transaction at a later date.
How Escrow Works
Escrow is a temporary holding of your money in a specific type of account, with a specific purpose. Will you be required to have an escrow account linked to your mortgage? Your lender should be able to tell you that.
Prior to buying a home you must demonstrate that you are a serious buyer by submitting earnest money along with your offer to purchase. That earnest money will be applied at your closing to either your down payment or your closing costs. It must be held in a ‘neutral’ account or Escrow.
After closing, escrow accounts are opened by your lender on your behalf, to collect and distribute money to pay real estate or property taxes as well as homeowners insurance. Lenders prefer escrow accounts because it assures them that these bills will be paid. The amount of both property taxes and homeowners insurance for the year is added up and then divided by 12. The resulting amount is added to the mortgage payment each month so that homeowners pay all three bills — the home loan, property taxes and insurance — monthly.
If insurance rates or taxes rise, the escrow payments will rise accordingly. Lenders often can’t calculate the exact amount to the penny, since tax bills can quickly change, but if they collect considerably more than necessary, they will need to give you a refund.
Should You Use an Escrow Account or Not?
Whether you need an escrow account is often up to the lender. If you have a choice in the matter, consider the following:
- Are you disciplined with money? If you have no trouble saving your money, then you may not wish to use an escrow account. People who are disciplined about saving for large payments don’t feel the sting of paying their insurance and taxes at the end of the year. On the other hand, if paying such a hefty bill is terrifying, then breaking it into 12 payments via an escrow account makes better sense.
- Will your money work harder elsewhere? A corollary to the above is that disciplined savers often invest their money. Such investments can yield good dividends. If the chunk of money you’d invest into the escrow account can make more for you elsewhere in a good investment for the remainder of the year, then it may make sense to forgo escrow, invest the amount and pay the bills when they are due instead of monthly.
Escrow payments aren’t for everyone, but they are a standard in the world of home ownership. Talk to your mortgage company or lender to determine if you’re required to open an escrow account when you buy your home.
Additional Resources for Home Buyers
- A Heads Up for Home Buyers
- Home Buyer’s Frequently Asked Questions
- Being Prepared
- For First-Time Buyers
- How Can I Help You?
- Do You Need a Buyer Agent
- Getting Pre-Approved
- Understanding Your Credit Score
- How Much Should I Offer?
- Offers and Purchase Agreements
- Who Pays for What?
