Escrow

Escrow has two lives in a home purchase, and the one that lasts is the account. During the purchase, a neutral party holds the buyer's deposit and the signed documents until every condition is met, and the house is in escrow until then. After closing, most lenders keep an escrow account for the life of the loan: each monthly payment carries one-twelfth of the year's property tax and homeowners insurance, the lender holds the money, and the lender pays each bill when it comes due. The escrow portion is not part of the loan and does not reduce the balance; it is a bill paid in monthly installments, and it is why a fixed-rate payment can still change from one year to the next.

In a sentence

• "Our escrow payment went up $75 a month because the county raised the property tax and the insurance renewed higher."
• "The house is in escrow until the inspection clears and the loan funds."
• "Escrow is the lender's sinking fund for the tax and insurance bills; it is not the loan and it is not the interest."

How it works

1. The lender totals the year's bills, the property tax and the homeowners insurance premium, plus any other charge it pays for you, such as flood insurance.
2. The total is divided by twelve and added to the principal and interest payment. Most lenders also keep a cushion, commonly up to two months of escrow payments, so the account is not empty when a bill lands.
3. The account is funded at closing with the first months of tax and insurance, which is part of the closing costs.
4. The lender pays each bill on its due date from the account and sends you a notice.
5. Once a year the lender reviews the account. If the bills rose, the monthly amount rises, and any shortage is spread over the coming year's payments or paid as a lump sum; a surplus is refunded or credited.

Monthly escrow = (yearly property tax + yearly insurance) ÷ 12

Lenders commonly require an escrow account when the down payment is small and may allow one to be waived with a larger down payment, sometimes for a fee, in which case the tax and insurance bills come to you and you pay them yourself.

An example

A $256,000 mortgage at 6.5% for 30 years, with a $3,600 yearly property tax bill and a $1,500 yearly homeowners insurance premium, the example's inputs, and no cushion for clarity.

Year one collects $5,100, but the tax bill and the renewed premium that land during the year come to $5,550, so the account ends $450 short. Year two's escrow payment covers the new bills at $462.50 a month plus the $450 spread over twelve months, and the total payment rises by $75 although the rate, the balance and the principal and interest have not changed.

Why it matters

Escrow moves two of the largest bills of home ownership out of your hands and into the payment, which is the convenience, and it hides them there, which is the risk. A household that budgets the mortgage as a fixed expense is surprised when the payment rises, and the rise is not a rate change but last year's tax bill catching up. Reading the yearly escrow statement shows what the house costs beyond the loan, and it is the place to catch a tax assessment or an insurance premium that deserves an appeal or a new quote. For anyone paying the bills without escrow, the same arithmetic applies in reverse: the tax and the premium are due in lump sums, and a monthly share has to be set aside for them or the bill lands on a single month.

Escrow versus a sinking fund

An escrow account is a sinking fund that the lender runs for you. Both turn a yearly bill into a monthly share and hold the money until the bill is due. The differences are control and interest: the lender sets the monthly amount, keeps a cushion, and in most states pays no interest on the balance, while a sinking fund you keep yourself is sized by you, earns whatever your savings account pays, and is yours to redirect. Without escrow, the tax and insurance bills belong in a sinking fund of your own, funded at the same monthly share.

Common questions

Is escrow part of the mortgage? No. It is collected with the mortgage payment, but it is not principal and not interest; it is money held to pay tax and insurance bills on your behalf, and it does not change the loan balance. When the loan is paid off, sold or refinanced, whatever is in the account is refunded to you.

Why did my mortgage payment go up if my rate is fixed? Because the escrow portion changed. Property tax and insurance premiums rise, and after the yearly review the lender raises the monthly share to match and adds any shortage from the past year. The principal and interest on a fixed-rate loan never move.

Is escrow required? Often, but not always. Lenders commonly require it when the down payment is under 20% and may waive it with a larger down payment, sometimes for a fee, and some loan programs require it for the life of the loan. Without escrow, the bills come to you and you pay them yourself.

Does an escrow account earn interest? Usually not. Some states require lenders to pay interest on escrow balances; in the rest, the money sits at no return, which is the cost of the convenience.

What is an escrow shortage? The gap between what the account collected and what the bills came to, usually because a tax or insurance bill rose after the monthly amount was set. The lender spreads it over the next year's payments or offers to take it as a lump sum, and raises the monthly share to cover the new bill amounts going forward.

Go deeper

• The Mortgage calculator estimates the full monthly payment on a home, principal and interest plus property tax, insurance, HOA dues and PMI, so the escrow portion shows next to the loan.
• How to budget for bills that aren't monthly turns each yearly or quarterly bill into a monthly share, which is the arithmetic escrow does for you and the one to use when it does not.