A quick glance at your mortgage statement likely reveals that your monthly payment is divided among principal, interest and escrow. The terms principal and interest are well-known to anyone who has taken out a loan…but some new homeowners may wonder “What is escrow?” “How does escrow work?” or “What is an escrow account?” The answers to these questions depend on when during the homeownership process the question is asked. Homebuyers typically encounter one form of escrow…homeowners face another.
Bottom Line Personal asked mortgage expert Keith Gumbinger what homebuyers and homeowners need to know about both these forms of escrow…
During the home-purchase process, an escrow account typically holds “earnest money”—that’s a deposit the would-be buyer puts in the hands of a third party to assure the seller that he/she is serious about purchasing the property. This earnest money often is 1% to 5% of the agreed-upon purchase price, and the third party that holds this money typically is an escrow company or local attorney recommended by the buyer’s real estate agent or mortgage broker.
When the home purchase is completed: This earnest money held in an escrow account typically is put toward the buyer’s downpayment and/or mortgage closing costs.
If the purchase falls through: The would-be buyer generally recovers his earnest money if one or more of the purchase contract’s contingencies wasn’t satisfied—for example, if the home inspection revealed significant problems. The seller, on the other hand, could potentially recoup the earnest money if the buyer backs out for reasons not covered by contractual contingencies.
Scam warning: Scammers sometimes try to trick would-be homebuyers into sending escrow money to fraudulent accounts. In one version of the escrow scam, a high-tech scammer hacks the computer system of a real escrow agency to find details about current clients, then sends e-mails or texts to those clients instructing them to send escrow payments to a particular account as soon as possible to avoid missing out on properties on which they’ve made offers. Problem: The account actually belongs to the scammer, who disappears with the money.
Self-defense: Homebuyers who receive escrow-deposit instructions should confirm that the instructions are legitimate by calling the real estate professionals they’re working with directly. Even better: If the third party selected to hold escrow funds is local, as often is the case, taking a bank check to the escrow holder’s office and obtaining a receipt can be safer than sending money digitally.
During homeownership, the homeowner’s mortgage lender likely will require that the borrower make monthly payments to an escrow account managed by the loan’s servicer. These escrow payments are included in the homeowner’s monthly mortgage payments and typically continue for the duration of the mortgage loan. The mortgage lender will use the money that accumulates in this escrow account to pay the borrower’s property tax bills, homeowners insurance bills and, in some cases, additional recurring homeownership costs, such as homeowners association fees, private mortgage insurance costs and flood insurance premiums. Mortgage servicers pay these expenses on behalf of their borrowers to protect the lenders’ financial interests. If a lender left it to a homeowner to pay his own insurance and taxes but that homeowner failed to do so—and also failed to pay his mortgage bills—then the home was destroyed or subject to a tax lien, that lender might not be able to recoup its costs by repossessing and selling the property.
Another reason mortgage lenders like escrow accounts: They typically invest these funds, generating revenue from them.
While mortgage lenders create escrow accounts for their own benefit, most homeowners consider these escrow accounts useful. Making a single monthly mortgage payment that includes property taxes and homeowners insurance is easier than having to remember to pay these recurring bills individually…and dividing up potentially large annual or semiannual bills into equal monthly payments can simplify budgeting. Downside to escrow accounts: They require homeowners to make payments toward tax and insurance bills months before those bills are due.
Caution: A mortgage loan’s monthly escrow payments can change over time—even with a fixed-rate mortgage. Mortgage lenders typically perform annual “escrow audits” to estimate the total tax, insurance and other bills that a particular escrow account will have to pay during the coming year. When taxes or insurance premiums increase, these audits are likely to conclude that there’s an “escrow shortage,” which the borrower will be required to cover with a one-time payment or higher monthly escrow payments.
Alternative: If you want to maintain access to your money for as long as possible—perhaps to keep that money invested—you might be able to request an “escrow waiver” from your lender. Many mortgage lenders and loans offer certain qualifying borrowers the option of paying their insurance and tax bills directly rather than through an escrow account—but expect to be charged a hefty fee to do so. Escrow waiver fees often are 0.125% or 0.25% of the loan amount.
