What Is Escrow? Is it Needed?

Written by Elijah BishopUpdated: 28th Dec 2021
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If you’re buying a home or taking out a mortgage for the first time, then you’re bound to hear or read these two terms: Escrow and Escrow Accounts.

And if you’re like millions of potential home buyers taking out a mortgageto finance their next home purchase, you may be wondering what these two terms mean.

This article will examine their meanings, roles, pros and cons, and why they are essential in any typical mortgage process.

What Is Escrow?

An escrow is a legal arrangement that allows a third party (usually a certified escrow company, escrow agent, or mortgage servicer) to act as an intermediary in a real estate or mortgage transaction until certain obligations are met.

In contrast, an escrow account is a holding account that helps collect, manage, and account for a borrower’s homeowners’ insurance and property taxes.

How Does Escrow Work?

While escrow is a common term in the financial industry, it still plays a huge role in real estate and mortgage transactions.

When a buyer and seller arrive at a purchase agreement in a typical real estate transaction, they select a neutral third-party individual or company to serve as an escrow agent.

When this happens, the escrow agent is empowered by law to take temporary possession of the buyers’ earnest money deposit, usually 1-2 percent of the home sale price.

In exchange, the seller agrees to take the property off the market. So, until the conclusion of the sale or mortgage closing, both the sellers’ property and the buyers’ earnest money deposit are considered to be in escrow.

On the other hand, Escrow in mortgage focuses more on your monthly mortgage payment than your property purchase.

When you borrow money from a mortgage lender to fund your home purchase, an escrow account will be created for you regardless of the amount.

And once created, your lender will deposit a prorated amount in the escrow account to cover the cost of mortgage insurance, property taxes, and home insurance premiums.

By collecting a fraction of your mortgage payments and depositing them on your behalf, your lender ensures that you do not default on your obligation to both the government and the insurance provider.

>> More: How to Apply for a Mortgage

Types of Escrow Accounts

Why there are several types of escrow accounts, in the real estate industry, escrow accounts are typically used for two primary purposes:

  • To protect a home buyer’s earnest money deposit so that the money goes to the right party in case of any eventualities.
  • To hold homeowners’ insurance premiums and property taxes

Due to the diverse uses it serves, there are two main types of escrow accounts when it comes to real estate and mortgage transactions.

One is used during the initial home buying process, while the other is used throughout the home loan life.

Escrow Accounts for Home Buying

When you’re buying a home, the purchase agreement between you and the home seller is expected to include earnest money or good faith deposit.

This deposit proves to the seller that you’re serious about going forward with the purchase. And if the sale falls through due to the buyer’s fault, the seller may have to take hold of the deposit.

However, if the deal goes through, the earnest money deposit is always added to the buyer’s down payment.

To protect both parties in a home buying transaction, an escrow account will be set up to hold the buyers’ deposit pending the sale’s closing.

Escrow Accounts for Taxes and Insurance

After closing your home loan, your lender will create an escrow account to cater to your property taxes and private mortgage insurance premiums.

With the creation of the escrow account, your online mortgage lenderor an external mortgage servicer will deposit a part of your monthly mortgage payment in escrow until your tax and insurance premiums payments are due.

When Is Escrow Needed in a Mortgage?

Escrow plays a considerable role during your initial home purchase and the life of your home loan. In a real estate purchase, an escrow guarantees both the home seller and home buyer.

So, once the buyer and seller agree on the purchase offer, a third-party intermediary ─ usually a title company or attorney will receive the signed purchase agreement and act as the escrow agent holding the deed and earnest money deposit. The escrow agent holds onto these items (earnest money and title deed) until the sale is completed.

In a mortgage, escrow or escrow account is needed under certain circumstances. If you’re applying for a government-backed loan like FHA and USDA loans, it is common for lenders to request that you get an escrow or escrow account.

Forconventional loans, the lender will decide whether or not a borrower needs an escrow account depending on the size of their down payment.

Even though it is possible not to get an escrow account, you should opt for one since it saves you from the inconvenience of having to pay for property taxes and insurance premiums yourself.

In addition, if you decide not to get an escrow account, you might need to pay your lender several hundreds of dollars to get a waiver.

>> More: Explore Government Home Loan Options

Who Manages an Escrow Account?

Now that you have deposited your earnest money or your lender has kept a portion of your monthly mortgage payments in an escrow account, you may be wondering who is responsible for managing the account.

Escrow accounts may be managed by various intermediaries depending on the type of service ─ mortgage or real estate.

However, it is common for escrow accounts to be managed by an escrow agent, escrow company, or a mortgage servicer.

Escrow Agents and Escrow Companies

If you’re buying a home, your escrow account may be managed by an escrow agent or mortgage servicing company.

Most of the time, the mortgage servicing company or agent is the same as the title company. In a typical real estate transaction, the escrow agent may hold onto a buyer’s earnest money deposit, deed, and other necessary paperwork pending the conclusion of the transaction.

More importantly, since the escrow agent or mortgage servicing company represents both the home seller and home buyer, it is common for both parties to split the escrow fees evenly.

Mortgage Servicers

Unlike escrow agents, mortgage servicers are focused on serving as mortgage transaction intermediaries.

Typically, a mortgage servicer is responsible for managing your mortgage from the point of your mortgage closing until you pay off the loan.

Also, mortgage servicers are charged with the duty of collecting your monthly mortgage payments, maintaining the records of your payments, and handling your escrow account.

Sometimes your lender may also act in the position of a mortgage servicer. While this is common, it is not always the case.

Lenders may decide to outsource the servicing rights to your loan to a different mortgage servicing company.

Having a mortgage servicer manage your escrow account relieves you of several duties.

You don’t have to send in your property tax or insurance-related payments ─ your mortgage servicer will be responsible for sending the payments to the necessary quarters as at when due.

How Much Do Escrow Fees Cost?

While there is no standard escrow fee, you may have to spend around 1-2% of your potential home purchase price on escrow fees.

This fee is usually added to your closing costs. However, unlike most real estate fees, you can easily negotiate escrow fees or the party responsible for paying escrow.

This means that you can politely request the seller or buyer to handle part or all the escrow fee, depending on the current market conditions.

If you’re buying a house, you will need to deposit at least 1-3% of the home sale price in a joint escrow account with the potential seller.

Usually referred to as an earnest money deposit, this deposit serves as proof of your seriousness about the purchase, and it legally requires the seller to take the property off the market pending the completion of the sale.

Upon completion of the sale, your earnest money deposit will be added to your down payment on the property.

While earnest money isn’t considered as a fee, you may end up losing it to the seller if you fail to follow up with the purchase.

What Are the Benefits of Escrow Accounts?

The primary benefit of getting an escrow account is the protection it offers you, whether as a home seller or home buyer.

It can also be beneficial after the conclusion of your homebuying journey. Having an escrow account can help you have money for your property taxes and insurance premiums as at when due.

In the following section, we’ll highlight some of the benefits of an escrow account for home buyers, homeowners, and lenders.

For Home Buyer

An escrow account is essential for protecting your earnest money deposit during a real estate sale transaction.

For instance, if you already have a signed purchase agreement with a seller, the sale falls through due to inspection-related issues.

If you’ve given the deposit directly to the seller, you may have some difficulty in getting back your deposit.

But with your deposit in the hands of a neutral third party, you are assured of receiving your deposit with no qualms.

For Homeowners

Getting an escrow account as a homeowner can relieve you of the need to come up with a lump sum to cover the payment of your property taxes and insurance premiums.

Another significant benefit is that you don’t have to bother about managing or keeping track of your tax and insurance premium payment due dates.

Once your property taxes and insurance premiums are due, it is the duty of your mortgage servicer to ensure that the bills are paid on time. So, as a homeowner, getting an escrow account helps you avoid late payments and no payments.

For Lenders

Since lenders have a higher investment in your home, they are more concerned about ensuring that you pay your property taxes and insurance premiums as at when due.

If you fail to pay your property tax, the local tax authority may place a lien (foreclose) on your property, leading to loss of money for the lender.

Also, if you fail to pay your homeowners insurance premiums, any significant damage to or loss of the property may lead to loss of money for the lender.

Getting an escrow account on the loan assures your lender that your insurance premium and taxes will be paid as at when due.

What Are the Disadvantages of Escrow Accounts?

While escrow accounts are generally considered good, but they also come with their share of disadvantages.

In terms of disadvantages, it is common for homeowners to face more burdens than home sellers and home buyers. Here are some of the disadvantages of using an escrow account.

  • Higher mortgage payments: Since escrow accounts are funded from your monthly mortgage payments, you are bound to be faced with a higher monthly mortgage bill.
  • Estimates might be incorrect for the amount of taxes: The amount you pay for your escrow depends on the current cost of your property taxes and homeowners’ insurance premium, which can vary from year to year. Your escrow agent or mortgage servicer will decide on the amount needed based on the previous year’s bill. And as your property value increases, your property taxes may also increase substantially. When a mortgage servicer manages your escrow account, they may fail to note the previous year’s increase, causing your current escrow to fall short.

Bottom Line: What is Escrow?

Escrow and escrow accounts play a huge role in any home buying or mortgage journey. An escrow protects buyers, sellers, and even lenders from any form of uncertainty. And it also offers homeowners an easy way to pay for their insurance premiums and taxes on time.

While it may seem like a good idea to go without an escrow account, getting one can save you from the responsibility of having to deal with handling the payment of your taxes and premiums yourself.

More importantly, some lenders may not request an escrow account if your down payment is above 20 percent.

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Elijah Bishop
Elijah Bishop

Elijah A. Bishop is a Senior Personal Finance Writer who has been writing about real estate and mortgages for years. He has a Bachelors of Arts Degree in Creative writing from Georgia State University and has also attended the Climer School of Real Estate. He also holds a realtor license and has been in and out of the US mortgage industry as a loan officer. Bringing over 15 years of experience, Elijah produces content that analyzes ethnicities, race, and financial well-being. His areas of expertise are mortgages, real estate, and personal loans.