Homeownership is saddled with a lot of financial terms that may end up sounding like another language to the average person. Sign on the dotted line of a fixed-rate or adjustable-rate mortgage, and you’re immediately responsible for paying back its principal by the end of its 15- or 30-year term—all while keeping its annual percentage rate (APR) and amortization in mind.
One term that you’re also likely to hear a lot in the pursuit of your next home is “escrow.” While that term has multiple meanings, depending on the context, the escrow associated with your mortgage is an important tool that you should know more about. Below are some of the less commonly known facts and features of a mortgage escrow.
- Mortgage escrow accounts are completely separate from the type of escrow that you may use when making your initial purchase. That escrow is used to protect both the buyer and seller.
- Rather than pay associated taxes and insurance fees on your own, an escrow can help simplify the process—for an added monthly cost, of course.
- When reassessed on an annual basis, your escrow payments could fluctuate.
What Is a Mortgage Escrow Account?
Designed to protect against fraud, nonpayment, or some other form of financial malfeasance, an escrow account provides some peace of mind to all parties involved in a transaction. As a concept, nearly every type of escrow account can be defined as a tool by which both sides of a transaction agree to let a third party hold on to assets or funds during a transaction. Once the transaction is completed, the escrow is disbursed to the receiving party.
In the case of a real estate transaction, an escrow account can be used either during the initial home buying process or—in the case of a mortgage escrow—after the property is closed upon. Lenders often require at the time of closing that you deposit two months’ worth of estimated property taxes, mortgage insurance fees, and homeowners insurance fees into your escrow account as part of your closing costs.
Typically, a mortgage escrow account is required if you attempt to purchase a home with a down payment of less than 20%. That’s because such a low down payment makes lenders worried about your creditworthiness. In their eyes, you’ll be more likely to miss property tax payments or fail to obtain homeowners insurance, making you a higher risk than other borrowers.
This long-term escrow account, which is sometimes called an impound account, is used to cover a variety of monthly costs that exist on top of your mortgage payments. Rather than having to save up for each of those payments, the mortgage lender calculates the yearly cost of each fee that the escrow covers and divides it up into a monthly amount. The result of that calculation is then added to your monthly mortgage payment and automatically deposited into the escrow account. It should be noted, however, that the monthly escrow payment isn’t considered part of the mortgage itself.
Escrow closings are also determined by whether the purchase occurs in an escrow state or attorney state.
What Fees Are Covered by a Mortgage Escrow?
From the outset, a mortgage escrow is meant to simplify the homeownership process as it relates to your monthly costs. By keeping a consistent balance in escrow each month, your escrow agent can cover various unavoidable fees and taxes. Though they don’t cover every monthly charge that you’ll experience as a homeowner, mortgage escrows cover some very important ones:
- Property taxes. Unless you qualify for an exemption, your property taxes are an unavoidable cost of homeownership in America. Based on the assessed value of your property and the municipal tax rate, property taxes help pay for local programs and services. Each mortgage payment will include one-twelfth of your yearly property tax bill.
- Insurance fees. Insurance helps protect your investment, so your mortgage lender will do what they can to ensure that your property is insured. A mortgage escrow specifically covers homeowners insurance, as well as any other hazard insurance needed. For instance, if your property is located in an area that regularly deals with wildfires, your mortgage escrow will likely cover fire insurance fees. Once again, the yearly cost for your ongoing premiums will be divided by 12 to cover each calendar month, even though the escrow account usually pays the insurance company twice a year.
- Mortgage insurance fees. Unlike the other mortgage fees that your escrow will cover, mortgage insurance is more for the lender’s peace of mind. According to the Consumer Financial Protection Bureau (CFPB), mortgage insurance is usually required when offering less than 20% as a down payment. As previously mentioned, offering such a low down payment makes you seem like a high-risk borrower. By taking out mortgage insurance, it protects the lender if you fall behind on your payments and lose the property through foreclosure.
Fees That a Mortgage Escrow Doesn’t Cover
- Non-property tax fees. Aside from your property taxes, you’re on your own. Supplemental or interim tax bills that may pop up following changes to the property, or any other additional taxes levied by the state, county, or municipality, are outside of the mortgage escrow’s purview.
- Homeowners association dues. Whether you love them or hate them, if you live in an area with a homeowners association (HOA), then any associated HOA fees are yours to handle. Failing to make these payments can result in additional late fees and even litigation, so it would behoove you to stay on top of them.
- Fees from nonessential insurance policies. Any additional insurance policies that you may take out on the property that the mortgage lender deems nonessential will be your responsibility as well. There are plenty of insurance policies that you don’t actually need, so be sure to stay away from them if you want to pay only for the premiums that your mortgage escrow covers.
Does an Escrow Accumulate Interest?
In nearly every case, mortgage escrows are not held in interest-bearing accounts. Though Congress made multiple attempts in the 1990s to require that interest be paid by the lender on mortgage escrow accounts, none was ever signed into law. That being said, lenders are required to make interest payments in Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont, and Wisconsin. Those interest payments are usually required to be paid directly to the customer, though there may be some exceptions to that rule.
What Happens During an Escrow Shortfall/Shortage?
Since your mortgage escrow is based on taxes and insurance premiums, it’s likely that costs will increase at some point. If such changes occur and your monthly escrow payments are unlikely to cover the difference, then you may be projected to fall into an escrow shortfall, or escrow shortage. An escrow shortage occurs when either your costs are more than anticipated or estimated costs for the next year show that your current monthly rate won’t be enough.
If your escrow balance actually falls below an acceptable level, then it’s very likely that your lender will automatically adjust the monthly payment accordingly. This means that you likely will have to contend with a larger monthly mortgage payment that will remain in effect even after the shortage is ameliorated.
Can You Put Extra Funding Into an Escrow Balance?
You don’t have to wait for a potential shortfall or shortage to increase your monthly mortgage escrow payment. Most lenders will happily accept extra funds as a cushion of sorts, as long as you specify that the money is for the escrow account. Any excess money left in the escrow account is likely to be refunded to you at the end of the year, so you lose nothing as long as you can afford to set aside that money in escrow.
You may want to make a larger escrow payment if you know that next year’s taxes and fees will be higher and that you want to pay the difference in one lump sum, rather than spread them out over 12 months of higher rates. Remember, however, that any money you deposit in your escrow account is money that’s not being used to pay down the mortgage itself.
An escrow waiver may be available for conventional mortgage loans. It allows you to cancel your mortgage escrow account and pay property taxes and insurance on your own. Such a waiver is subject to lender discretion and could require a fee. Lenders may also waive escrowed taxes and insurance if there is sufficient equity in the house, but they can revoke the waiver if the borrower fails to pay those taxes and insurance premiums.