What Is Escrow and How Does It Work?

Buying a new home is an exciting time, but it can also be overwhelming, especially if you’re a first-time home buyer. You’ll likely hear lots of new phrases and terms, like escrow, used in different contexts. Here’s how to understand the word and what it means for the home-buying process.

Escrow FAQs

What Is Escrow?

By definition, escrow is a legal arrangement in which a neutral third party temporarily holds large sums of money or property until a particular condition has been met.

How Does Escrow Work?

In real estate, escrow is most often used for two reasons:

1. To protect the buyer’s good faith, an earnest money deposit goes to the right party according to the conditions of the sale of the house.
2. After the purchase of a home is complete, an escrow account may be used to hold a homeowner’s funds for tax and insurance purposes.

Once you’ve put an offer in on a home, you’ll likely give the seller what’s called an earnest money deposit. This is a good faith deposit that the seller will get to keep if you back out of the deal or violate your contract. The amount of earnest money depends on the home’s final purchase price. Typically, it’s 1-2% of the home’s final purchase price.   

Once the real estate deal closes, the earnest money is released. Usually, the buyers get the money back and apply it to their down payment and mortgage closing costs. 

However, if the home sale falls through, the buyers will generally lose the earnest money and won’t get it back. For example, if the buyer changes their mind and decides not to go through with the purchase, the seller typically keeps the earnest money. If the sale of the home falls through due to certain circumstances, like a home inspection reveals serious problems, buyers will usually receive their earnest money back.

How Do Monthly Escrow Payments Work?

Once you own your home, you’ll likely see references to an escrow account on your mortgage statements. Unlike the escrow account used while closing on your home, this type of escrow account is one you’ll use throughout the life of your home loan. 

Often, lenders will require that you enter into an escrow agreement when you sign your mortgage contract. The lender will figure out what extra money will be needed to pay for things, like property taxes and homeowners insurance payments, and set up deposits into this account. 

Lenders usually require at least two months’ worth of insurance and property tax funds in the impound account at closing. The amount you have to prepay into an impound account for these costs is based on your location. 

Keep in mind that these funds aren’t additional closing costs. Instead, you’re prepaying extra months of home insurance and property tax bills that you would be required to pay when due. Your mortgage servicer will list the initial escrow payment amount due at closing on your loan estimate.

What Do Escrow Accounts Cover?

When your property taxes and insurance payments are due, your lender will use this account to pay these bills on your behalf. This ensures that you won’t ever pay these bills late. In order to set up this account, you’ll have to prepay some of your escrow at closing. For example, if your homeowners policy costs $1,000 in a year, you might need to provide that amount at closing so that your account has sufficient funds to pay for your first year’s coverage.

While an escrow account makes it easy to pay for your homeowners insurance and property taxes, there are other homeownership fees that these accounts do not cover. Fees like utility bills or HOA fees are not included in your escrow account. Additionally, things like supplemental tax bills are also not covered by escrow accounts. These one-time tax bills include issues due to a change in ownership or new construction.

Are Escrow Accounts Required?

An escrow account for paying property tax and homeowners insurance is generally required for Veteran Affairs loans(VA), Federal Housing Administration loans (FHA) and conventional loans. Lenders may sometimes allow the homeowner to pay the property tax and home insurance as a lump sum instead of setting up an escrow account, but be aware that if you waive escrow, your lender may charge you a fee or an increased interest rate.

While you may not be required to set up an escrow account, you can choose to open one voluntarily to break up insurance and property tax payments into smaller amounts, keep track of monthly payment due dates and avoid surprise bills at the end of the tax year. 

What Are the Pros and Cons of an Escrow Account?

There are several benefits of an escrow account. It helps protect both the buyer and the seller during the real estate transaction. It will also help protect you as a homeowner, ensuring you have the money necessary to pay for property taxes and homeowners insurance.

There are some disadvantages, too. Since an escrow account is funded through your monthly mortgage payment, it’ll likely make your monthly bill higher than it would be without escrow. It can also be incorrectly estimated. This is because your property taxes and homeowners insurance costs can change from year to year. So, when a servicer estimates your escrow cost, they might not take into consideration a jump in property taxes, meaning your escrow may come up short. When this happens, you’ll need to pay the difference out of your own pocket. 

On the flip side, you can get your escrow money back if there is any money left over in your escrow account after paying the taxes and insurance for the year. Your servicer will cut you an escrow refund check for the remaining balance or roll it over to next year’s escrow payments.

The Coverage You Need

Your new home is more than just a structure, it’s where your family’s story begins. It’s crucial to have the right protection in place and your local Farm Bureau agent is here to help. Whether you need homeowners insurance for your new home or you’re looking for a competitive quote, your agent is only a phone call away.