What is escrow and how does it work?

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As a home buyer, your title company will require you to use an escrow account as part of the real estate purchasing process. But it also often plays a role in your monthly mortgage payments.

In home buying, escrow is a legal and financial arrangement where a neutral third party temporarily holds money, assets, or documents on behalf of two other parties. The funds are only released when specific conditions in a contract are met. After closing, escrow pays property taxes, mortgage insurance, and homeowners premiums.

Key takeaways:

• Purchase escrow accounts hold and manage funds safely. They're neutral third-party arrangements that hold money, assets, or documents until contract conditions are met.
• You often get a new escrow account after closing. Your mortgage servicer uses escrow to manage your property tax and homeowners insurance payments, along with mortgage insurance, if necessary.
• Having an escrow account protects buyers, sellers, and lenders. It removes the risk of funds being released prematurely or bills going unpaid, giving you peace of mind.

What is an escrow account?

There are two types of escrow accounts. A purchase escrow account is managed by a neutral third-party. It’s used to hold a buyer’s good faith deposit during the sale. Mortgage servicers manage a separate escrow account after close for tax and insurance payments that become an ongoing part of your mortgage payment.

Earnest money escrow vs. mortgage escrow

There's a distinct difference between purchase-agreement escrow and ongoing mortgage escrow. A third party sets up an earnest money escrow account to safely hold a deposit to demonstrate to the seller that you’re serious about making the purchase.

If you’ve taken out a mortgage to purchase a property, your lender will also set up an ongoing mortgage escrow account. This account holds funds to pay for your taxes and homeowners insurance as part of your monthly mortgage payment. The account is managed by the servicer you make your mortgage payments to, which may or may not be the same as the original lender.

Escrow or impound accounts

Depending on where you live, you might hear your mortgage escrow account referred to as an impound account. Whether it’s called an escrow or impound account, the function remains the same. The terminology tends to change based on where you live.

How does escrow work?

From the moment you sign a purchase agreement to the ongoing management of your home loan, escrow plays a vital role. Let's look at a step-by-step explanation of the process so you know exactly what to expect.

How escrow works when buying a home

When you sign a purchase agreement, your initial deposit is placed into an escrow account managed by a title company or real estate attorney. Should the contract fall through due to actions that leave the buyer at fault, the seller generally keeps the earnest money.

If the home purchase is successfully completed, the buyer can apply the earnest money toward their down payment or closing costs.

What happens when a home is in escrow?

When a home is in escrow, it means the buyer and seller have agreed to terms, but the sale hasn't closed yet. The money sits safely while you inspect the home, finalize your loan, and clear any other contract contingencies.

During this period, an escrow agent oversees the preparation of documents, ensuring the buyer gets the property title, and the seller receives their payment simultaneously. A closing is also sometimes called a close of escrow for this reason.

How mortgage escrow works after closing

Once the sale is complete, your mortgage servicer takes the reins if an escrow account is established. As part of every month’s mortgage payment, your loan servicer sets aside a portion of the funds paid into the escrow account.

The servicer holds this money until your tax and insurance payments are due. When the bills arrive, your servicer pays them directly on your behalf, preventing you from being caught unaware by unexpectedly large expenses.

What is an escrow payment?

An escrow payment is the portion of your monthly mortgage payment specifically set aside for your escrowed expenses. A standard mortgage payment includes principal, interest, taxes, and insurance. The tax and insurance portions make up your escrow payment.

How your escrow payment is calculated

Each year, your home mortgage servicer will calculate escrow payments for the year ahead based on the amount of your current year’s bills. They take the annual cost of your property taxes, homeowners insurance, and mortgage insurance, if applicable. This sum is divided by 12.

Because the amount of money required is a moving target, your servicer may require a cushion. Federal law allows servicers to require up to 2 months of extra escrow payments to protect against unexpected bill increases, although specific states may impose further limitations on this amount.

What is an escrow balance?

Your escrow balance is the amount of money currently held in your account for future bills. Because you contribute to the account monthly, but the tax and insurance bills are only paid once or twice a year, your escrow balance will grow and shrink naturally over time.

What is an escrow analysis?

Be advised that as part of servicing the loan, your servicer will analyze your escrow account on an annual basis to make sure they’re not collecting too much or too little. This escrow analysis reviews the past year's payments and upcoming bills to determine if your monthly payment needs to change.

What are escrow fees?

Setting up and managing an escrow account during a real estate transaction involves administrative work. Escrow fees cover the cost of the neutral third party managing the funds and documents. Because an escrow company works for both the buyer and the seller, the fee for their services is usually split evenly between the two parties.

What happens if you have an escrow shortage or surplus?

Because property taxes and homeowners insurance costs are a moving target, your escrow analysis may reveal a discrepancy.

Should the analysis of your escrow account determine that too much money has been collected for taxes and insurance, your servicer will give you an escrow refund for the surplus. If the surplus is greater than $50 after accounting for the amounts due and the applicable cushion, your servicer must send an escrow refund. Otherwise, it can be applied to your account.

If your property taxes or insurance premiums increase, you may face an escrow shortage. If you have a shortage, you have the option of paying it off in a single lump-sum payment or spreading the shortage amount out over the next year.

Even if you make a single payment, you should know that your regular monthly escrow amount is going to go up to account for the base increase in taxes or insurance.

Who manages an escrow account?

Escrow accounts are managed differently depending on where you are in the process. Before you buy the home, the account between you and the seller is managed by a neutral third-party. Once you close your loan, the escrow account is administered by your mortgage servicer.

Escrow companies, escrow agents and title companies

As you go through the home buying process, escrow may be managed by an escrow company, an escrow agent, a real estate attorney, or a title company. The professional you’ve chosen not only manages the buyer’s deposit, but they may also be responsible for holding the deed and other transaction documents until closing.

Mortgage servicers

After closing, your mortgage servicer oversees the account. Mortgage servicers are responsible for collecting your mortgage payment, maintaining records, and managing your escrow account. By collecting payments and forwarding them to the tax authority and insurance company, the servicer saves you from having to track multiple due dates.

What mortgage escrow covers and doesn’t cover

Escrow accounts help you set aside funds for future expenses, but it's important to clarify which housing costs are commonly included and which costs homeowners must handle separately.

What mortgage escrow usually includes

A mortgage escrow account typically includes the primary expenses that protect the property and the lender's interest in it. This includes:

• Property taxes
• Homeowners insurance
• Mortgage insurance (if applicable to your loan type)

What mortgage escrow usually does not include

Escrow accounts don’t cover every charge related to homeownership. Costs generally outside of escrow include:

• Utilities (electricity, gas, water, internet)
• Maintenance and upkeep
• Homeowners association (HOA) fees
• Supplemental tax bills

Supplemental tax bills may arise from changes in property ownership or new construction in California.

Pros and cons of escrow accounts

Using an escrow account provides a cost-effective and convenient way to automate payments, but you'll still want to take a balanced look at the benefits and drawbacks.

Benefits for home buyers, homeowners, and lenders

For home buyers, an escrow account helps safeguard and protect your deposit as you go through the purchasing process. If the sale fails to complete due to inspection issues, a neutral third party ensures your funds are returned promptly.

For homeowners, having an escrow account minimizes financial surprises. You can budget more effectively because you're making manageable payments in advance all year long. Also helpful is not having to keep tabs on due dates; your mortgage servicer handles them and makes certain the charges are paid on time.

For lenders, escrow ensures that insurance and property taxes are being paid in full. Should tax bills go unpaid, the tax authority could put a lien on the home. In the event homeowners insurance lapses, significant damage could result in a substantial decrease in property value. Escrow mitigates these risks.

Drawbacks for homeowners

While you won't encounter significant disadvantages, there are a few drawbacks to consider. First, funding an escrow account means your monthly mortgage payments are higher than they would be if you were only paying principal and interest.

Second, your servicer may make lower escrow estimates than required. Upon first moving into your new home, the property will likely be reassessed by the government for tax purposes, causing taxes to increase. Because calculations are just an estimate, your escrow balance may come up short.

Finally, because the amount needed for escrow is reassessed each year, your monthly payment is subject to changes and increases over the life of your loan.

Do you need an escrow account?

You need an escrow account in a few situations. Escrow requirements vary by loan type, lender, and borrower circumstances.

When escrow may be required

Certain home loan borrowers must have an escrow account in place:

• FHA loans: The Federal Housing Administration requires all borrowers to have an escrow account.¹
• VA loans²: Escrow is generally required, but borrowers may qualify for an exception if they meet standard down payment and equity requirements and have a minimum credit score of 620.
• Conventional loans: Lenders typically require escrow, but escrow can be waived if they meet standard equity or down payment and credit score requirements.
• Flood insurance: Properties that have required flood insurance often mandate an escrow account.

Even if you meet the equity criteria, you also must be current on your tax and insurance payments to be eligible to waive escrow.

Can you manage escrow yourself?

If you qualify for an escrow waiver, it’s possible to pay your property taxes and homeowners insurance directly instead of using mortgage escrow. However, doing so means you’ll have to save for those massive payments on your own.

Keep in mind that paying property taxes and insurance on your own can mean managing multiple payments that may come due at different dates with bigger bills.

Can you remove escrow from your mortgage?

Yes, you can remove escrow from your mortgage in many cases, but you'll want to make certain that you meet qualifying criteria. The same rules that apply to escrow waivers generally apply to escrow removal.

Mortgage servicers will each have their own requirements for escrow removal. Additionally, FHA loans require escrow. Rocket Mortgage requires escrow for flood insurance as well.

FAQ

We’ve covered the core concepts, but let’s answer a few more questions you may have about escrow.

What does escrow on a house mean?

Escrow on a house means that a neutral third party is holding your earnest money deposit and real estate documents. This ensures the funds remain safe while you finalize your loan, perform inspections, and meet all the contractual conditions of the home purchase.

Do you get escrow money back?

You don't typically get earnest money back as a cash refund unless the real estate transaction falls through due to a contingency. Usually, it is applied directly to your down payment at closing.

However, if your ongoing mortgage escrow account collects too much money, you will receive an escrow refund check after your annual analysis if the surplus is greater than $50.

Is having escrow good or bad?

Having an escrow account is very good for budgeting and convenience, as it automates your tax and insurance payments. Some homeowners may view it as a drawback because it increases your monthly mortgage payment and removes your ability to earn interest on those funds in a personal savings account.

How long does escrow last?

Purchase escrow only lasts through the transaction process, typically taking a few weeks to a couple of months until closing. Mortgage escrow, however, may last throughout the entire life of your loan.

Who chooses the escrow company?

The escrow company may be selected by the buyer and seller as part of the real estate transaction process. Once you close, any escrow account is administered by your mortgage servicer.

What happens to escrow if you refinance?

Refinancing can affect how an existing escrow account is handled. In some cases, the funds are rolled over directly into the new loan in a process called netting escrows. In other instances, the remaining amounts are refunded to you, and you must fund a new account. It may depend on whether you’re working with the same lender.

The bottom line: Escrow holds funds for future payments

Escrow helps protect buyers, sellers, homeowners, and lenders by holding funds safely until contract conditions are met or tax and insurance bills are due. Escrow provides a handy way to ensure that important bills get paid in a timely fashion without having to keep track of due dates or worry about having to make one lump-sum payment.

Feeling confident you’re ready to take the next step? Start the approval process today with Rocket Mortgage.

¹ Rocket Mortgage is not acting on behalf of FHA or HUD.

² Rocket Mortgage is a VA-approved lender, not endorsed or sponsored by the Dept. of Veterans Affairs or any government agency.

Rocket Mortgage is a trademark or service mark of Rocket Mortgage LLC or its affiliates.