If you’re in the market to buy a house, you’ve probably been hearing a lot of different terms and phrases. It’s OK if you’re not familiar with all of them. Taking the time to learn this language won’t just help you understand what everyone is talking about, it’ll also allow you to plan better and make smarter financial decisions as you search for your home.
One term you’ve likely heard thrown about quite a bit is escrow.
Escrow accounts play an important role at two key points in becoming a homeowner: First, during the homebuying process and second, as you pay your mortgage. Below, we take a closer look at what an escrow account is, why you might encounter these accounts, and also answer a few other questions you may have.
What is escrow?
Escrow is a term used to refer to a legal agreement in which a third party holds funds or assets until certain terms have been met, at which point the funds (or assets) are dispersed to the appropriate party.
As noted above, escrow accounts are commonly used in the world of real estate, but they can also be used in other scenarios as well, such as during business negotiations or for other large purchases.
Escrow in real estate
In the world of real estate, escrow accounts are usually used in two distinct ways: 1) To hold the buyer’s earnest money deposit once he or she has made an offer on a property and 2) as a part of your mortgage.
When a buyer makes an offer on a home and the seller accepts that offer, the buyer will often put down what is known as an earnest money deposit. This deposit is typically between 1 percent and 3 percent of the sale price of the home and is meant to show the seller that the buyer is serious about buying the house.
Earnest money typically works like this:
- If the deal falls through because the buyer fails to meet their obligations or simply backs out, then the seller gets to keep the funds.
- If the deal falls through because of contingencies outlined in the purchase agreement (such as a failed home inspection), then the buyer gets the earnest money back.
- If the deal goes through as planned, then the money can either be applied to the buyer’s down payment or closing costs.
While it isn’t required, it’s typically recommended that earnest money be held in an escrow account until the deal is finalized — not paid directly to the seller. This way, you can feel more confident that you will be able to recoup the funds if that becomes necessary.
What is escrow on a mortgage?
Once you’ve purchased your home, you may encounter escrow again if it is required by your mortgage lender. In this regard, the escrow account is specifically used to hold funds that will ultimately be used to pay your property taxes and homeowner’s insurance premiums when the time comes.
If it is required, it will typically work like this:
- Your lender or mortgage servicer will estimate your annual property tax liability and homeowner’s insurance premium and then divide that number by 12.
- This number will be added to your monthly mortgage payment.
- As you make your monthly payments, the servicer will take the amounts earmarked for property taxes and homeowner’s insurance and hold it in an escrow account.
- When your taxes and insurance premiums are due, the servicer will automatically make the payments or will send you a check with which to make the payment yourself.
Why do lenders like to use escrow accounts for this purpose? For a few reasons. If you were to fall behind on your property taxes, it could result in a lien on your home and put your mortgage at risk. Likewise, if you miss your homeowner's insurance payments and your coverage lapses, you and your mortgage holder are at significant risk if your home is damaged or destroyed. Escrow accounts, therefore, lower the risk to the lender.
Of course, many homeowners also enjoy paying their mortgage through an escrow account, for the simple reason that it makes budgeting and planning for these large payments automatic.
Are escrow accounts required for mortgages?
It depends. Most lenders require borrowers to contribute to an escrow account. Other lenders may allow you to opt out of escrow if you meet certain requirements, such as providing a down payment of a certain size and maintaining a minimum credit score. If you are unsure about the requirements, you should speak with your lender.
Factoring escrow payments into your budget
While this may seem obvious, escrow payments increase what you’ll owe on your mortgage monthly. That means the principal and interest cost is only a part of what you’ll ultimately pay. So you’ll want to get a sense of how much you will contribute monthly for escrow and factor the cost into your monthly budget.
As you evaluate your budget and savings and begin planning for homeownership, it’s also a great time to take a closer look at your overall financial plan to ensure that all of the different components are still working together as efficiently as possible. A financial advisor can help you understand the bigger picture even as you work toward specific goals, including homeownership.