Escrow: What Is It And How Does It Work?

If you’re buying a home, you’ll probably hear the word “escrow” used in a few different contexts. Essentially, escrow is a financial arrangement in which a neutral third party holds funds or assets on behalf of two parties involved in a transaction until specific conditions are met. This is especially relevant during the home buying process.

Whether you’re a home buyer, seller or a current homeowner, understanding how escrow works and its benefits can help you navigate the complexities of real estate transactions with more confidence and ease.

How Does Escrow Work?

An escrow agreement is used in real estate transactions to protect both home buyers and sellers during the home buying process. Throughout the term of the mortgage, an escrow account will hold funds for taxes and homeowners insurance.

What Is An Escrow Account?

In real estate, escrow is typically used for two reasons:

• To protect the buyer’s Good Faith Deposit, so the money goes to the right party according to the conditions of the sale.
• To hold a homeowner’s funds for property taxes and homeowners insurance.

Because of the different purposes served, there are two types of escrow accounts. One is used during the home buying process, while the other is used throughout the life of your loan.

Escrow Accounts For Home Buying

When you’re buying a home, your purchase agreement will usually include a good faith deposit, also known as earnest money. This deposit shows the seller that you’re serious about purchasing the home. If the contract falls through due to the fault of the buyer, the seller usually gets to keep the money. If the home purchase is successful, the deposit will be applied to the buyer’s down payment.

To protect both the buyer and the seller, an escrow account is set up to hold the deposit. The good faith deposit sits in the escrow account until the transaction closes.

Sometimes, funds are held in another type of escrow account past the completion of the sale of the home. This is called an escrow holdback. There are many reasons an escrow holdback may be needed. For example, perhaps you agreed that the seller can stay in the home an extra month, or there are outstanding bills on the home that the seller is responsible for (like a water bill).

If you’re building a new home, money may remain in escrow until you’ve signed off on all the work. Once the conditions are met, the money will be released to the right party.

Escrow Accounts For Taxes And Insurance

Your mortgage lender may also establish an escrow account to pay for your taxes and homeowners insurance. In some states, these are called impound accounts. Each month, your mortgage servicer takes a portion of your monthly mortgage payment and holds it in the escrow account until your tax and insurance payments are due.

The amount required for escrow is a moving target because your tax bill and insurance premiums can change from year to year. Your servicer will determine your escrow payments for the next year based on what bills they paid the previous year. To ensure there’s enough cash in escrow, most lenders require a minimum of 2 months’ worth of extra payments to be held in your account.

Your lender or servicer will analyze your escrow account annually to make sure they’re not collecting too much or too little. If their analysis of your escrow account determines that they’ve collected too much money for taxes and insurance, they’ll give you what’s called an escrow refund.

How Do I Calculate Escrow?

The amount required for escrow is variable because your tax bill and insurance premiums can change from year to year. That said, your servicer will determine your escrow payments for the next year based on what bills they paid the previous year. They will use documents from the loan closing, taxing authority and your insurance company to arrive at the total figure. They may then divide this figure by 12, and thus they arrive at your monthly escrow payment (which is added to your monthly mortgage bill).

To ensure there’s enough cash in escrow, most lenders require a minimum of two months’ worth of extra payments to be held in your account.

Who Manages An Escrow Account?

Escrow accounts may be handled by a variety of third parties, such as an escrow company, escrow agent or mortgage servicer. Where you are in the process will determine who manages the account.

Escrow Companies And Escrow Agents

When you’re buying a home, escrow may be managed by a mortgage servicing company or agent. The escrow agent or company is sometimes the same as the title company.

The escrow company not only manages the buyer’s deposit, but they may also be responsible for holding the deed and other documents related to the sale of the home.

Because the escrow company is working for both the buyer and the seller in the real estate transaction, the fee for their services is usually split evenly between the two parties.

Mortgage Servicers

Your mortgage servicer manages your mortgage from closing until you pay off your loan. Mortgage servicers are responsible for collecting your mortgage payment, maintaining the records of payments and managing your escrow account. Some lenders service their own loans while others sell the servicing rights, so it’s worth checking into your servicer’s policies.

Your mortgage servicer will handle tax and insurance payments for you; however, if you make an insurance provider or policy change, you’ll need to update your servicer with the new information.

The Benefits Of An Escrow Account

The biggest benefit of having a Rocket Mortgage^® escrow account is that you’ll have peace of mind knowing you’re being taken care of by the most awarded mortgage company ever, based on J.D. Power’s consumer surveys.*

For Home Buyers

An escrow account is key to protecting your deposit during a home sale. Say you have a purchase agreement, but the sale falls through due to a problem found during the home inspection.

If you’d given your deposit directly to the seller, there’s a chance they wouldn’t return your deposit. But since the deposit is being held by a third party, you can be confident it will be returned according to your agreement.

For Homeowners

An escrow account takes the pressure off you to come up with a lump sum to cover taxes and insurance. Since you’re paying for your taxes and insurance throughout the year, the payments can be more manageable.

Another bonus is that you don’t have to keep track of the different due dates. When your tax bills and insurance premiums are due, your mortgage servicer will use your escrow account to make sure those bills are paid on time, every time. That way, you’re not responsible for any late payments.

Your servicer will even cover bills for you if your escrow account is short on funds, but you’ll be responsible for making up any negative balance later.

For Lenders

Lenders have a vested interest in making sure your property taxes and insurance get paid for two reasons:

If your tax bills don’t get paid, the tax authority could put a lien on your home — which could end up costing the lender money if the tax authority chooses to foreclose.

If your homeowners insurance coverage lapses, significant damage to — or loss of — the home could result in a substantial decrease in its value.

Having an escrow account on the loan allows the lender to ensure the bills get paid.

The Drawbacks Of Escrow Accounts For Homeowners

Although there aren’t any significant disadvantages to having a mortgage escrow account, there are a few things to take into consideration:

Higher Monthly Mortgage Payments

An escrow account is funded through your monthly mortgage payment, making your monthly bill higher than it would be without escrow. However, this also means that you don’t have to pay your taxes or insurance in a lump sum when they’re due, so this is actually not a disadvantage when you think about it.

In general, escrow adds about 1% – 2% to the total purchase price of a home in escrow fees.

Lower Escrow Estimates Than Actually Required

The amount needed for your escrow depends on your property taxes and homeowners insurance costs, which can change from year to year. The amount needed will be based on the previous year’s bills.

When you first move into your home, your property is reassessed for tax purposes. This may cause your property taxes to increase substantially, especially if the home value has risen. When a servicer estimates the escrow, they may not be able to predict an increase in your property taxes. Rocket has processes in place to reasonably predict tax bills on home purchases, but not all loan originators or servicers do.

Because of this, your escrow may come up short. If that happens, you’ll have to pay the difference with an increase in your monthly escrow payment.

On the flip side, if there’s any money left over in your escrow after paying the taxes and insurance for the year, your servicer will refund you the excess funds.

Changes To Your Monthly Payment

Escrow is reassessed at least once each year and, depending on whether you were short or had excess money, your servicer will come up with a new estimate for the year. If you’re short, your mortgage payment will go up because the estimate will increase.

What Escrow Accounts Don’t Cover

Escrow accounts are designed to manage specific recurring expenses, but they don’t cover all the costs associated with homeownership. For instance, payments for electricity, gas, water and other utilities must be handled directly by the homeowner. Similarly, if you live in a community with a homeowners association (HOA), you’ll need to pay those fees separately as they aren’t included in escrow.

Supplemental tax bills, which may arise from changes in property ownership or new construction, are also not managed through your escrow account.

Do You Need An Escrow Account?

It may be possible to pay for property taxes and insurance yourself instead of using an escrow account. Doing so will lower your monthly mortgage payment, but you’ll have to save for tax and insurance payments on your own.

Plus, you may incur a fee for managing your own taxes and insurance. Managing escrow accounts is often a free service provided by servicers like Rocket Mortgage, so it often simply doesn’t make financial sense to opt out of escrow for your mortgage.

Escrow waiver requirements differ based on if you're opting not to have the account when you get the loan or choosing to remove it later on. If you don't want taxes and insurance escrow to begin with, you just have to meet minimum down payment or equity and credit score requirements for your loan. 

If you're looking to drop your escrow account at some point after closing, there are several requirements, but the one that's most visible is likely minimum equity requirements. Some conventional loans require 20% equity based on the original value before you can close an existing escrow account.

The only loans that require escrow accounts throughout the life of the mortgage are from the Federal Housing Administration (FHA). The required FHA mortgage insurance premiums are paid out of the escrow account.

Sometimes, lenders require escrow for property taxes but not homeowners insurance.

Can You Remove Escrow from Your Mortgage?

In most cases, you can remove the escrow from your mortgage — but that doesn’t mean it’s always a good idea. However, if you’ve decided that removing escrow is the best choice for you, you’ll need to make sure you meet certain criteria with your lender and other involved parties.

For example, some lenders require that you have a certain loan-to-value ratio (LTV) of 80% or less in some cases, and an escrow account with a positive balance. You’ll likely also need proof of a current homeowners insurance policy.

Again, some loans require escrow (like FHA loans or those with required flood insurance), so removing escrow won’t be an option in some cases.

The Bottom Line: Escrow Protects Both Buyers and Sellers

Escrow is an important part of purchasing a home. It protects buyers and sellers during home sales, and it offers a convenient way for you to pay for your taxes and insurance.

An escrow account is sometimes required, and sometimes it’s not. It depends on the type of loan you get, as well as your financial profile.

It may be tempting to go without an escrow account because it could mean a lower monthly mortgage payment. But in the long run, escrow provides peace of mind by removing your responsibility of making sure those important bills get paid (and having to pay them in one lump sum when they are due).

Interested in buying a home? Begin the approval process today with Rocket Mortgage.

*Rocket Mortgage has won more awards than any other brand in the J.D. Power U.S. Mortgage Servicer Satisfaction Studies. This customer satisfaction study has been conducted annually from 2002 – 2024. Visit JDPower.com/Awards for more information.