What is an escrow balance, and who manages it?

Owning a home comes with a lot of financial responsibilities – especially when it comes to paying property taxes or repaying the loan (fixed-rate or adjustable-rate mortgage) in monthly installments for a 15- or 30-year period. That’s when the concept of escrow comes into play. So, what is an escrow balance, and who manages it?

Simply put, an escrow account is like a middleman holding something valuable for you until a deal is done. When it comes to buying a house, an escrow account holds onto your money for specific purposes and payments. 

Loan lenders too want to make sure important payments such as property taxes and insurance are paid on time. So, they ask you to have an escrow account. It’s like a safety net to ensure that these payments are covered, protecting both you and the lender.

What is an escrow account?

An escrow account is like a special bank account managed by your lender (or someone they trust). Each month, a part of your mortgage payment goes into this account, covering expenses like property taxes and home insurance. When these bills are due, the lender uses the escrow account to pay property taxes and insurance premiums. 

Escrow accounts became more common after the tough times in 2007-09 when many people couldn’t pay their taxes and insurance. To avoid such problems, a government agency called the Consumer Financial Protection Bureau (CFPB) made rules about how escrow accounts should work.

In the case of buying a house, an escrow account helps prevent fraud or nonpayment in a deal. It gives everyone involved peace of mind. In simple terms, it’s an agreement where a neutral third party holds onto money or assets until the deal is done. After that, the third party releases the funds to the rightful recipient. The release of funds depends on fulfilling pre-established conditions. This setup is often used for assets such as real estate, money, stocks, and securities, which are held in escrow until the financial transaction process is finalized.

What does an escrow account cover?

An escrow account covers your monthly mortgage payments, interest, property taxes, home insurance, and even flood insurance if you need it. If these costs go up, your monthly payments might change even if you have a fixed-rate mortgage. Escrow accounts make sure everything gets paid on time.

For example, let’s say your property taxes are $2,500 a year, and your home insurance is $1,200 a year. Your lender might ask you to pay an extra $300 every month into your escrow account. This way, you don’t have to stress about paying $3,700 each year. It’s like a savings account that helps you and your lender avoid problems with property taxes or homeowners insurance in case of an untoward event.

Keep in mind that mortgage escrows won’t cover non-property tax fees, such as supplemental or interim tax bills and additional state or municipal taxes. Homeowners Association (HOA) fees too are not included. And, failing to pay them can lead to late fees or litigation. Any nonessential insurance policies taken out on the property are also the homeowner’s responsibility, as the mortgage escrow only covers essential premiums.

What are the pros and cons of having an escrow account?

What is an escrow balance?

Your escrow balance is the money set aside for you in your escrow account, also known as an impound account in some places. Every month, you contribute to this account as a part of your usual mortgage payment.

In the case of a mortgage escrow account, based on your loan’s amortization schedule, your monthly payment is split into different parts. When you pay your monthly loan amount, it’s divided into two parts: one for the loan amount (principal) and the other for the interest. At first, a bigger chunk goes to cover the interest, but as time goes on, more of your payment goes toward reducing the actual loan amount (principal).

The third part of what you pay each month goes into your escrow balance. This is like a savings account for your property taxes and home insurance. When these bills come up, the money from your escrow account is used to pay them.

Since property taxes and insurance costs can go up, your escrow payments might not be enough to cover the increase. If that happens, your mortgage company will adjust your monthly payment and let you know. This new amount or escrow balance will stay until they check the escrow account again. Keep in mind that the escrow balance is different from the principal balance.

As mentioned, the money in your escrow balance covers payments such as insurance and property taxes. On the other hand, your principal balance is the remaining amount you owe on your mortgage.

How is escrow balance calculated in mortgages?

When establishing your escrow account, the lender calculates your yearly tax and insurance costs, divides the total by 12 (for the next 12 months), and includes that in your monthly mortgage statement. Every month, they put a portion of your payment into the account and handle your insurance and tax payments when they’re due. 

To account for unexpected expenses, your lender might need an “escrow cushion,” as permitted by state law. 

You don’t need to wait for a potential shortage to raise your monthly mortgage escrow payment. Many lenders are happy to receive extra funds, provided you specify that the money is for the escrow account. Any surplus escrow balance is likely to be refunded to you at the end of the year. So, you don’t lose anything as long as you can afford to set aside that money in escrow.

What’s more, if you anticipate higher taxes and fees the next year and prefer to pay the difference in a lump sum instead of spreading it over 12 months, you might consider making a larger escrow payment.

Read more: Why did my escrow go up?

Who manages the funds in an escrow account?

Various third parties may handle escrow accounts. 

Escrow companies and escrow agents

During a home purchase, an escrow company or agent may handle escrow. Sometimes, it can be the same as the title company.
The escrow company or agent doesn’t just look after the buyer’s deposit, they also take care of holding onto the deed and other property-related paperwork. Since the escrow company helps both the buyer and seller in the real estate deal, the costs or fees are usually shared equally by both parties.

Mortgage servicers

Your mortgage servicer handles your mortgage from closing until you fully repay your loan. They collect your mortgage payment, maintain payment records, and manage your escrow account.

With your mortgage servicer overseeing your escrow account, you don’t need to worry about your tax or insurance bills – your servicer ensures they know who to pay and when.

Can you avoid setting up an escrow account?

Some lenders might let you handle paying taxes and insurance on your own. In most cases, banks use the loan-to-value (LTV) ratio to decide if you need an escrow account. If your mortgage is 80% or less of your home’s value, you can choose not to have an escrow account. But if you have less than 20% equity, lenders require escrow. And private mortgage insurance (PMI). Loans backed by the Federal Housing Administration (FHA) and Veterans Affairs (VA) also need you to have an escrow account.

Last thoughts

A mortgage escrow account is distinct from the escrow used by homebuyers during a home purchase. There, a third party holds the funds until the real estate transaction is completed between the buyer and seller. 

A mortgage escrow account covers taxes and insurance fees associated with the property. These are paid on your behalf by your escrow agent using your escrow balance. What’s more, this balance is periodically reviewed to prevent any potential shortfalls.

Written by Ramona Sinha. January 12, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.