“Escrow” is a term you'll hear a lot when you’re buying a house. You might nod your head in agreement when your mortgage broker talks about your escrow account and putting money in escrow, but you silently wondering “Where am I putting what?”
Let’s break down what exactly escrow accounts are so you can master this tricky real estate term.
What is an escrow account?
An escrow account is a financial arrangement where a neutral third party holds money or documents until certain conditions are met. This third party – often a title company, attorney or escrow agent – ensures that funds are handled securely, contract terms are followed and payments are distributed correctly. An escrow account protects everyone involved in the real estate transaction.
The two main types of escrow accounts
There are two types of escrow accounts that may be used when you buy or sell a home: escrow during the home purchase and ongoing escrow after closing.
Escrow used before or during the time of closing
An escrow officer holds all the important documents and deposits while the buyer and seller work out the details. Here’s how it works:
- Once an offer is accepted, an escrow account is opened
- The buyer deposits earnest money (a good faith deposit)
- The escrow agent holds funds and documents
- Conditions like inspections and financing must be completed
Then, the escrow office makes sure the closing goes smoothly and everyone gets paid what they’re owed. After the closing, the escrow agent records the deed and title transfer that make the home officially yours.
What is earnest money in escrow?
Earnest money is a “good faith” deposit, often around 1–2% of the home price, that shows you are serious about buying a home. This money is held in escrow, rather than being given directly to the seller, and is applied towards the purchase of your home at closing. Depending on contract terms, if the sale does not go through, your money could either be returned or forfeited.
Ongoing escrow after closing
After you purchase a new home, your mortgage lender typically sets up an escrow account to pay obligations, such as property taxes and home insurance premiums, on your behalf. Here’s how it works: you pay monthly installments for property taxes and home insurance along with your monthly mortgage payment. Then, your mortgage servicer will deposit these monthly installments into the escrow account. Your servicer uses the funds to pay your bills when they’re due, typically once or twice a year.
At the end of the year, the lender adjusts your monthly escrow amount based on the actual property taxes and home insurance costs. If you didn’t pay enough, you’re usually allowed to spread the difference out over the following year, and if you paid too much, the lender will refund your money.
Why escrow accounts are important
Many lenders require that you pay your property taxes and home insurance using an escrow account, so they can make sure that the bill gets paid. Sometimes, escrow accounts may also be required by law. However, even if your lender does not require an escrow account, consider requesting one voluntarily. An escrow account makes it easier to budget for your large property-related bills by paying small amounts with each mortgage payment. That way you don’t have to scramble to pay a large property tax bill or insurance premium when it comes due.
Also note that the federal Real Estate Settlement Procedures Act limits the amount of money lenders can require to be held in an escrow account. So if you feel the amount you’re paying into the escrow account is too much or you’re having difficulty breaking down the different amounts going into the account, contact your mortgage lender.
Why understanding escrow matters
Without escrow, real estate transactions would be riskier and more complicated. By understanding how escrow works, you can feel more confident during closing, better understand your monthly mortgage payments and avoid confusion about where your money is going.