Escrow comes up a lot during the homebuying process. If you’re a first-time homebuyer, you may be asking yourself questions like: What is escrow on a mortgage? What are escrow payments?

“Escrow is the practice of handing money over to a third party while in the process of finalizing a major financial transaction, like a real estate purchase,” says Martin Orefice, CEO of Rent To Own Labs, a real estate platform based in Orlando, Florida.

That third party manages the escrow account to ensure the transaction is conducted fairly, legally, and correctly — that every last cent goes where it should, and is fully accounted for.

Escrow accounts are used in two ways that affect homeowners: to oversee the homebuying transaction, and to ensure essential fees like property taxes and homeowners insurance are paid in full and on time.

What Is Escrow on a Mortgage?

You can think of escrow as an independent account managed by a third party. It’s used to collect, hold, and pay out funds, and handle related documents required for a major financial transaction.

Escrow accounts can be managed by an escrow company, a title company, a law firm, or your mortgage servicer. The manager ensures the transaction is handled in a timely, fair, and accurate manner.

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Escrow for Buying or Selling a Home

When a home is being sold, an escrow account is used to manage the sale.

Buyers pay an initial deposit to start the escrow process. You can find this amount listed in Section G on Page 2 of the loan estimate that lenders provide when you apply for a mortgage. Make sure to confirm that amount when you get your closing disclosure, as it can change in the interim.

The buyer and their lender also will deposit the down payment, the mortgage principal, and any other funds required by the sales agreement into the escrow account.

When the conditions of the sale are met, the escrow manager disburses that money to pay all fees, closing costs, and the seller’s lien holder. Once everything’s paid, the remaining cash goes to the seller.

If funds need to remain in escrow past the finalization of the sale, it’s called escrow holdback. This can occur when the home needs repairs, or the seller has to stay in it longer than expected.

The escrow fee typically is split between the buyer and seller. The amount is generally 1% to 2% of the home purchase price.

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Escrow for Property Taxes and Insurance

You also may use an escrow account to pay expenses such as property taxes, homeowners insurance, homeowners association fees, and flood insurance. This also is known as an impound account, and is created by your lender when you get your mortgage.

Each year, your lender will review the activity in your escrow account and estimate what you’ll owe in taxes and insurance in the coming year. You’ll receive a summary of this report, which is called an escrow analysis.

The lender will break down those fees into a monthly amount, which is added to your mortgage payment and kept in the escrow account. When your taxes or insurance need to be paid, the money is already set aside, and your lender pays those bills on your behalf out of the escrow account.

There can be cases where the estimate doesn’t match what you wind up owing. If your escrow balance is short, you will have to make up the difference. If the escrow balance is over, you’ll be refunded the extra amount.

This process ensures these bills get paid in full and on time, which is why many lenders require escrow accounts. In some places, escrow accounts are required by law.

The type of mortgage you have also will determine whether an escrow account is required. For example, if you have a loan backed by the Federal Housing Administration, you must have an escrow account.

Homeowners without escrow accounts have to pay their property taxes and homeowners insurance directly. There can be serious consequences for failing to pay property taxes, including fines, penalties, tax liens, or even foreclosure. If you don’t pay for homeowners insurance, your lender may buy it on your behalf and bill you for it.

Lenders prefer escrow accounts because a home that is uninsured or subject to a tax lien risks the lender’s ability to recover its investment if it needs to foreclose.

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Disadvantages and Benefits of Escrow Accounts

There are some drawbacks to using an escrow account, including:

  • Your monthly payment is higher.
  • You can’t access or otherwise invest the cash impounded in an escrow account.
  • You may still have a surprise bill to pay if your escrow balance falls short of your actual bills.

There also are significant benefits of escrow accounts to consider:

  • The buyer’s and seller’s interests and funds are protected during a home sale.
  • You can pay tax and insurance bills as you go instead of paying a large bill every six or 12 months.
  • Your lender handles paying your insurance and tax bills on time for you.

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Escrow Account Basics FAQ

Here are the answers to frequently asked questions about escrow.

Can you remove escrow from your mortgage?

Lenders generally will let you remove an escrow account if your loan is in good standing and the value of your home meets a minimum 80% loan-to-value ratio. However, requirements vary by lender and by state.

You’ll need to make a written request to your lender to file what’s often called an escrow waiver. Your lender also can explain its specific requirements for cancellation.

Can you change insurance providers with escrow?

Yes. Be sure to share the new policy information with your escrow manager, so they’re in the loop and paying the right provider.

Can you withdraw money from an escrow account?

You may access the money in your escrow account, but there are trade-offs involved.

“Taking your money out of an escrow account before completing the transaction will effectively mean canceling the transaction, and may result in penalties or fees,” Orefice says.

If there’s money left over in your escrow account after your insurance and taxes have been paid, then your escrow manager will refund you the difference. This is called an escrow refund.

You also may be able to get an escrow refund if you pay off your mortgage completely or get a better rate on your homeowners insurance with a different provider.

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The Bottom Line on Escrow Accounts

If you’re buying a house, escrow is an important part of the process in several ways. During the sale of a home, an escrow account ensures a legal and orderly transaction. After you’ve bought a home, an escrow account offers an easy way to collect funds on a monthly basis to pay large bills, such as homeowners insurance and property taxes. In both cases, escrow is a way homebuyers can have confidence that their most significant transactions will go smoothly.