What is an Escrow Account?

The potential to lose collateral is the primary reason lenders set up escrow accounts. By taking responsibility for paying a borrower’s annual property tax bill and annual homeowner’s insurance premium, the lender knows that in the event of an accidental fire or a borrower’s failure to pay his or her property taxes, its collateral is safe. The insurance company will cover the loss and the state won’t have to foreclose.

Lenders set aside money to cover these bills in what is called an escrow account. Each month when you make your mortgage payment, you actually pay additional funds. How much extra you pay is estimated based on current year amounts due. When the lender receives your monthly mortgage payment, the additional funds are diverted into the escrow account where they remain until it is time to pay these bills.

There are limits on the amount the lender can require borrowers to deposit for these and other property-related charges. Limits are defined in RESPA, the Real Estate Settlement Procedures Act. Each year, a review of a borrower’s escrow account is conducted by the lender. Shortages or overages are reported to the borrower and if the excess is $50 or more, the lender must return the overage to the borrower.

Sometimes lenders prefer there to be a “cushion” in the account. Again, this is a lender preference, not a RESPA requirement. However RESPA does set cushion limits at 1/6th of the total amount due for the property-related bills paid using escrow account funds, which calculates into approximately two escrow payments.

Establishment of an escrow account is not required under RESPA. But certain types of loans require escrow accounts as a condition for approval. FHA, VA and some other government loans require this and so do certain lenders of conventional loans. In these cases, this requirement cannot be waived.

However, if your loan type or lender does not require establishment of an escrow account, and you are not currently paying PMI, you can make your property tax and insurance payments on your own. To do this, contact your lender and ask that the escrow account be closed. And be sure to set aside ample funds so you can pay these bills when they come due.

On our site you’ll find a list of HUD-prepared Frequently Asked Questions regarding escrow accounts.