When you purchase a home with the help of a lender, the lender will likely set up an escrow account for you as well. The lender collects the money from you on a monthly basis for property taxes and homeowner's insurance, holds it in the escrow account, and then pays those bills on your behalf when they come due. For the lender, the main purpose of an escrow account is to protect their lienholder interest in your home. The borrower benefits by spreading out payments on a monthly basis for bills that are due semi-annually or annually.
How does an escrow account work?
When establishing an escrow account, your lender will calculate the total annual payments for your property taxes and homeowner's insurance. The annual amount will then be divided by 12 to calculate your monthly escrow payment. This monthly amount is added to your principal and interest payment to make your total mortgage payment. You might hear your full monthly payment referred to by the acronym "PITI", for Principal, Interest, Taxes & Insurance. Lenders also typically require you to maintain a cushion of two months of escrow payments in the account at all times.
Every year, your lender will review your escrow account to ensure it has the right amount of funds. The lender will recalculate your payments based on the previous year's property tax and insurance costs. If there were a shortage within your account, your lender would require you to make a one-time payment or have an increased mortgage payment the following year. If there was an overage in your account, your lender will give you a check for that amount and might decrease your escrow payment for next year.
Advantages of escrow accounts
- Budgeting and bill payment will be simpler because you do not have to think about setting aside money to make your annual or semi-annual property tax and homeowner's insurance payments.
- If you make your mortgage payment each month, you will always have the money available to make the property tax and insurance payment, and will never pay late penalties.
- Depending on where you live and your lender, your escrow account may pay interest on the account balance. The interest rate on your escrow account might be higher than market rates on other types of personal deposit accounts.
Disadvantages of escrow accounts
- When closing on your home mortgage, you will typically need to come up with more money to establish the buffer of two months payments in your escrow account. That amount could be larger, depending on when your property tax and homeowner's insurance payments are due.
- Your monthly mortgage payment is larger when you have to make a payment into an escrow account in addition to your regular principal and interest payment.
- The bank gets to hold your money, rather than you retaining control and having the money available to make investments.
Avoiding an escrow account
If you would prefer to not have an escrow account, you will need to negotiate it with your lender. The lender might be willing to allow you to manage your property taxes and homeowner's insurance payments rather than using an escrow account. Typically, you'll need to have put at least 20% down on your home, be a prior homeowner, or have a large cushion in your bank account. If you choose to forego the escrow account, you should budget carefully to ensure you have the money available to make your property tax and homeowner's insurance payments when they are due.