How Does Escrow Work?
If you have heard the word “escrow” used two different ways and felt a little confused, you are not alone. Escrow actually refers to two separate things, depending on where you are in the home buying process.
The first is a temporary account used during a home purchase, holding your earnest money until closing. The second is an ongoing account tied to your mortgage, used to pay your property taxes and homeowners insurance for as long as you own the home. This guide walks through both, how each one works, and what happens if something goes wrong along the way.
Two Types of Escrow at a Glance
Before going through the details, it helps to see how these two accounts compare side by side.
| Purchase escrow | Mortgage escrow | |
|---|---|---|
| When it exists | From your accepted offer until closing | For as long as you have the loan |
| What it holds | Earnest money deposit | Property tax and insurance payments |
| Who manages it | An escrow or title company (or an attorney, in attorney states) | Your loan servicer |
| What happens at the end | Applied to your down payment or costs at closing | Continues until the loan is paid off, refinanced, or waived |
The rest of this guide covers each one in order, starting with the purchase itself.
Escrow During a Home Purchase
When your offer on a home is accepted, you typically put down earnest money, a deposit that shows the seller you are serious about the purchase. This money does not go directly to the seller. Instead, it goes into a neutral escrow account, held by a third party until closing.
Earnest money deposits are typically 1 percent to 2 percent of the purchase price. For example, on a $350,000 home, that would usually be $3,500 to $7,000.
Here is what happens to that money, depending on how the sale goes.
- If the sale closes normally, the earnest money is applied toward your down payment or closing costs.
- If you cancel the deal within the terms of a contingency you included in your contract, such as an inspection or financing contingency, you generally get the earnest money back.
- If you back out of the deal for a reason not covered by a contingency, the seller may be entitled to keep it.
This is why it is worth understanding exactly which contingencies are in your contract before you make an offer.
Escrow After You Own the Home
Once you close on the home, a second type of escrow account often comes into play, and this one is not temporary. Many mortgage lenders require you to pay into an escrow account every month, alongside your principal and interest payment.
This account is used to cover a few specific bills on your behalf.
- Property taxes
- Homeowners insurance
- Private mortgage insurance, if your loan requires it
It generally does not cover things like HOA dues or utility bills. Those remain your responsibility to pay directly.
Instead of you receiving a large tax bill once or twice a year, your servicer collects a portion of that cost every month and pays the bill for you when it comes due. This is often more convenient for buyers, since it turns a few large bills into one predictable monthly amount.
The Pros and Cons of an Escrow Account
Like most financial tools, a mortgage escrow account comes with real advantages and a few tradeoffs.
Pros:
- Your property tax and insurance bills are paid automatically and on time, so you do not have to remember due dates yourself.
- The cost is spread evenly across the year, rather than showing up as one or two large bills.
- It reduces the chance of a missed payment leading to a tax lien or a lapse in insurance coverage.
Cons:
- You do not control how the money is invested while it sits in the account, and in most cases, you do not earn interest on it.
- Your monthly payment can rise without much warning if your property taxes or insurance premiums go up.
- Some borrowers would rather manage that money themselves and pay the bills directly, especially if they are confident in their own budgeting.
Whether an escrow account is beneficial for you depends on how much you value convenience versus control. The next section explains who actually manages the account at each stage, since that affects your options.
Who Actually Manages Your Escrow Account
There are two different managers at two different stages of the process.
During the purchase itself, a neutral escrow or title company holds and disburses your earnest money, following the terms of your purchase contract. In a small number of states, called attorney states, a real estate attorney handles this role instead. Both California and Montana are escrow states, so if you are buying in Bakersfield or the Flathead Valley, your purchase escrow will go through an escrow or title company rather than an attorney.
After closing, a different party takes over. Your loan servicer manages the ongoing mortgage escrow account, collects the monthly portion from your payment, and pays your tax and insurance bills for you. It is worth noting that your loan servicer is not always the same company that originally approved your loan, since loans are often sold or transferred to a different servicer after closing. If that happens, you will receive a notice, and your escrow account transfers along with the loan.
A Simple Example of How Your Escrow Payment Is Calculated
Here is a simple way to see how the monthly number is worked out.
Let’s say your annual property tax bill is $3,600, and your annual homeowners insurance premium is $1,200. Added together, that comes to $4,800 per year.
Divide that by 12, and your base monthly escrow payment would be $400. Lenders also typically add a small cushion on top of this to cover the chance that costs rise slightly before the next review. Under federal rules, this cushion cannot be larger than one sixth of your estimated annual escrow payments, which works out to about two extra months of payments.
So in this example, your servicer might collect closer to $460 to $470 a month, once the cushion is included. This amount can change each year, based on your actual tax and insurance costs.
What Happens If Your Escrow Account Comes Up Short?
Property tax bills and insurance premiums do not always stay the same from year to year. When either one rises, your escrow account can end up with less money than it needs, a situation known as an escrow shortage.
When your servicer reviews your account each year and finds a shortage, you are usually given two options.
- Pay the shortage as a one-time lump sum
- Spread the shortage out over the next 12 months, added to your regular monthly payment
Most borrowers choose the second option, since it avoids a large one-time cost. Either way, your servicer is required to notify you of the shortage and explain your options in writing.
On the other side of this, if your escrow account review finds a surplus of $50 or more, federal rules require your servicer to refund that amount to you within 30 days. If the surplus is less than $50, the servicer can choose to refund it or apply it toward next year’s payments.
Can You Avoid Having an Escrow Account?
In some cases, yes, though it depends on your loan type and how much equity you have.
FHA and USDA loans generally require an escrow account for the life of the loan. Conventional loan borrowers have more flexibility. Once you reach at least 20 percent equity in your home, meaning your loan balance is under 80 percent of the home’s value, many lenders will allow you to request a waiver and pay your own taxes and insurance directly.
This ties back to the pros and cons covered earlier. If you would rather manage those payments yourself and are confident you will not miss a due date, a waiver may be worth asking your lender about. If you prefer the predictability of one combined monthly payment, keeping the escrow account may be the simpler choice.
Common Questions About Escrow
Can I get my earnest money back if the deal falls through?
In most cases, yes, as long as you cancel the deal within the terms of a contingency written into your contract, such as an inspection or financing contingency. If you cancel outside of those terms, the seller may be entitled to keep it.
Does my escrow payment ever change?
Yes. Your servicer reviews your escrow account once a year and adjusts your monthly payment up or down, based on your actual property tax and insurance costs.
Can I shop around for my own escrow or title company?
In many cases, yes. It is worth asking your agent or lender whether you have a say in which company handles your purchase escrow, since this can sometimes save you money on fees.
What happens to my escrow account when I pay off or refinance my mortgage?
When you pay off your loan or refinance with a new one, your existing escrow account is closed, and any remaining balance is refunded to you, usually within a few weeks.
Ready to Understand Your Numbers? Talk to an Advisor
Escrow can feel confusing at first, but once you see how each type works, it becomes a lot more manageable.
Contact the Lockhart Real Estate Advisors team if you have questions about earnest money, your mortgage escrow account, or anything else along the way to closing.