What is escrow and how does it work?

An escrow account is a neutral, third-party account used to hold and manage funds during a home purchase and throughout the life of a mortgage. Throughout the homebuying process, escrow protects the good-faith deposit you provide to the seller when your offer is accepted. These funds are held in escrow to ensure all parties meet their obligations before the sale is finalized. After closing, your lender typically sets up another escrow account to collect a portion of your monthly mortgage payment. Those funds are used to pay property taxes and homeowner's insurance on your behalf when they're due.

Escrow is one of many unfamiliar terms you may encounter as a first-time homebuyer. When a seller accepts your offer, your real estate agent might mention the need to place funds in escrow to help seal the deal. You may also learn about the need to set funds aside in escrow during the mortgage application process.

Escrow doesn't have to be a mystery. In fact, demystifying the escrow process is a crucial step for any homebuyer. To help you formulate the right questions for your real estate agent or lender, explore why funds are placed in escrow, how a third-party agent handles an escrow account and where the money in the account goes.

What does escrow mean on a house?

Escrow accounts are used to enforce the legality of many types of contracts, including home purchases. In a real estate transaction, escrow helps ensure that funds and documents are only released when all parties meet the conditions outlined in the purchase agreement. An escrow agent serves as a neutral third party outside of the transaction, holding funds or documents until all parties meet the contractual conditions of the sale.

Escrow protects both the buyer and seller. When a house doesn't pass inspection and the purchase agreement allows the buyer to withdraw their offer, they may also request the return of their earnest money held in escrow. This prevents a situation in which earnest funds are used by the seller or held in violation of the home purchase contract. If a dispute arises between the buyer and seller, the funds will remain in escrow until the matter is settled between both parties.

For homebuyers, escrow accounts serve two distinct purposes: purchase escrow during the homebuying process and mortgage escrow after closing.

2 types of escrow accounts in real estate

The two types of escrow are often a source of confusion for first-time buyers. It's helpful to remember that escrow accounts are involved in many types of legal transactions. For a home purchase, each escrow account has a separate and distinct purpose.

Purchase escrow: Protecting your earnest money deposit

When a seller accepts an offer, the buyer typically submits an earnest money deposit of 1-3% of the sale price as a show of good faith. A neutral escrow agent holds the funds until the transaction closes or is terminated. If the home purchase closes as expected, the agent releases the earnest money from escrow to apply to the down payment at closing.

Escrow protects both the buyer and seller. If the purchase is canceled for a reason covered under the purchase agreement, the buyer may be entitled to a refund of their earnest money held in escrow. If the purchase falls through, the signed purchase agreement determines how the funds are distributed.

Mortgage escrow: Managing taxes and insurance after closing

After closing, lenders typically set up a mortgage escrow account, also called an impound account, to collect funds for property taxes and home insurance. If an escrow account is required, your lender collects an additional amount with your monthly mortgage payment and deposits those funds into the escrow account to pay eligible expenses on your behalf. When applicable, private mortgage insurance (PMI) and flood insurance may also be held in escrow.

The amount sent to escrow each month is based on the estimated annual property taxes and insurance costs for the home. Annual estimates are divided by 12 to compute a monthly amount, which is added to the monthly mortgage payment. For example, if a homeowner owes an estimated $3,600 in annual taxes and $1,200 in annual insurance costs, the escrow total would equal $4,800, or $400 per month.

Lenders may also collect a cushion of up to two months of escrow payments at closing. This can help cover any shortfalls and prevent a large-one time bill if taxes or insurance costs rise unexpectedly during the year.

How the escrow process works step by step

Buyers can expect the following series of escrow events as they prepare for closing and begin making mortgage payments:

1. Purchase escrow is established: When a seller accepts the buyer's offer, a purchase escrow account is opened to hold the buyer's earnest money deposit.
2. Escrow period begins: The buyer ticks due diligence items off their list, including a home inspection, title search and a property appraisal. Contingencies in the purchase agreement determine whether the buyer can exit without losing their deposit.
3. Closing of the purchase escrow account at settlement: Once all conditions are met, the lender funds the mortgage, the deed transfers and the purchase escrow account closes. Earnest money is applied to the buyer's closing costs or down payment.
4. Post-closing escrow account opens: The lender establishes a mortgage escrow account to hold a portion of each monthly mortgage payment.
5. Bills are paid on the buyer's behalf: When property tax and insurance bills are due, the lender pays them directly from the escrow account.
6. Annual escrow review: Each year, the lender conducts an escrow analysis to determine any shortages or surpluses.

Escrow shortages, surpluses and payment adjustments

Property tax assessments and insurance premiums can fluctuate from year to year. When this happens, monthly escrow payments adjust to avoid a surplus or shortfall in the account.

If the escrow account doesn't have enough funds to cover actual tax and insurance bills, the lender may advance the funds needed to make those payments on time. The account will then have a shortage that must be repaid. Depending on the lender's policies and the amount owed, homeowners may be able to repay the shortage through a lump-sum payment or by spreading the amount across future monthly payments. The annual escrow disclosure statement will outline any shortages, surpluses and available repayment options.

At the end of the year, the escrow account may also have a surplus. This occurs when funds collected exceed the amount owed. Most lenders refund surpluses above a set threshold, such as $50.

Lenders are required to provide homeowners with an annual statement to help them understand how and why escrow payments changed. Staying up to date with local property tax changes and insurance premiums can help you avoid unnecessary surprises.

Is escrow required? When you can opt out

Generally, escrow is required for borrowers with conventional mortgage loans who put down less than 20% of the home purchase price. FHA loans and VA loans may have different escrow requirements. Borrowers who prefer to budget and manage their own tax and insurance payments may have the option to opt out of a mortgage escrow account.

Some lenders allow a waiver of escrow for homeowners with sufficient equity and a strong credit history. Opting out transfers the responsibility of paying tax and insurance bills directly to the homeowner. Depending on your loan type, you may be required to maintain an escrow account for the life of the loan. If your loan closes with an escrow account, you may be able to request cancellation at a later date, subject to lender requirements and any applicable fees. First-time buyers should clarify escrow requirements with their lender during the application process and when reviewing final loan documents at settlement.

Ask early and close with confidence

Escrow is a standard, routine part of buying a home, but it shouldn't feel like a mystery. Protect your peace of mind by asking questions during the mortgage application process, well before you sit down to sign your final paperwork.

If you have questions about how escrow works or what to expect, connect with a Citizens Loan Officer today to get the answers you need.

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Frequently asked questions

Do I need an escrow account with my mortgage?

Whether an escrow account is required depends on your loan program and your down payment amount. Many lenders, including Citizens, require an escrow account for borrowers who put down less than 20%. When you apply for your loan, your lender will let you know whether an escrow account will be required and give you an estimate of your future monthly escrow payments.

What does an escrow account pay for?

An escrow account typically covers property taxes, homeowners insurance premiums and, if applicable, flood insurance and private mortgage insurance. Escrow accounts usually do not cover homeowner association fees, non-required insurance or special tax assessments. The lender estimates your annual taxes and insurance, divides the total costs by 12 and adds that amount to your monthly mortgage payment.

What types of bills are paid out of an escrow account?

Your escrow payment can change from year to year following the lender’s annual review. If your property taxes or insurance premiums go up or down, your monthly escrow amount will be adjusted accordingly. You will receive a notification of any changes to your monthly payment.

What is the difference between escrow during home buying and escrow after closing?

During the homebuying process, an escrow account holds your earnest money deposit and other prepaid funds until the transaction closes. After closing, escrow refers to a separate account managed by your lender to collect and pay your property taxes and insurance. Both escrow accounts serve a protective function, but they operate at different stages of homeownership.