When you get a mortgage, you will likely hear the word "escrow" during your closing meetings. Escrow is a financial arrangement where a third party holds funds on behalf of the transaction parties. In mortgage lending, an escrow account is a reserve account managed by your lender to pay for your recurring property expenses.
How a Mortgage Escrow Account Works
Your monthly mortgage payment does not just cover principal and interest. If your lender sets up an escrow account, a portion of your monthly payment is diverted into this account to build up savings. When your annual property taxes and homeowners insurance bills arrive, the lender pays them directly out of your escrow account on your behalf.
This system ensures that these essential bills are always paid on time, protecting both you from penalties and the lender from losing the property to a tax foreclosure.
"Escrow accounts prevent homeowners from facing large, unexpected annual tax and insurance bills by spreading them into 12 equal monthly installments."
Components of an Escrow Payment
Your monthly escrow payment is calculated by taking your estimated annual property taxes and homeowners insurance premiums and dividing them by 12. Lenders are also permitted by law to hold a "cushion" of up to two months of payments to account for rate increases.
Why Escrow Payments Can Change
Because property taxes and homeowners insurance rates fluctuate, your lender will perform an annual escrow analysis. If taxes or insurance premiums go up, you will have an "escrow shortage" and your monthly mortgage payment will increase to cover the difference. Conversely, if your expenses decrease, you will receive an escrow refund check.