Escrow

How Escrow Works, Step by Step

Escrow is meant to lower risk for everyone involved in a transaction. Here is how it typically works when you buy a home and when you have a mortgage.

During a home purchase

1. Offer accepted and contract signed. Buyer and seller agree on price and terms in writing. The contract spells out when money will be deposited into escrow and what conditions must be met.
2. Buyer deposits earnest money. The buyer sends a good faith deposit, often 1% to 3% of the purchase price, into an escrow account held by a neutral party, not directly to the seller.
3. Escrow instructions are created. The escrow holder follows written instructions, which describe what must happen before funds are released. Conditions usually include inspections, title work, appraisal, and final loan approval.
4. Documents and funds are collected. During the escrow period, the escrow holder gathers the purchase contract, loan documents, title reports, and any required disclosures, along with funds from the buyer and lender.
5. Conditions are verified. The escrow holder confirms that all contract conditions have been met: inspections cleared or negotiated, title issues resolved, and loan ready to fund.
6. Closing and disbursement. Once conditions are satisfied, the escrow holder releases funds to the seller, pays agreed closing costs, and arranges for the deed and other documents to be recorded.

During the life of a mortgage

After closing, escrow often continues in the form of a mortgage escrow account that is used to pay property-related costs.

1. Lender estimates annual costs. The lender or servicer estimates how much will be owed over the next 12 months for property taxes, homeowners insurance, and certain other required items.
2. Monthly escrow payment is set. Your monthly mortgage payment is split into two parts: principal and interest on the loan, and an escrow portion for taxes and insurance. The escrow portion is typically one-twelfth of the annual estimate, sometimes with a small cushion.
3. Funds are held in escrow. Each month, the escrow portion of your payment is deposited into the escrow account. You do not access this account directly; the servicer manages it for you.
4. Bills are paid when due. When property tax and insurance bills come due, the servicer pays them from the escrow account on your behalf, using the funds that have accumulated.
5. Annual escrow analysis. At least once a year, the servicer reviews the account to see whether there is a shortage or surplus, based on actual tax and insurance bills. Your monthly payment may be adjusted up or down.

Key protections escrow provides

• For buyers: The earnest money is protected until contract conditions are met. If the contract allows you to cancel for specific reasons, your deposit can be returned instead of going to the seller.
• For sellers: Escrow shows the buyer is committed and has funds available, reducing the risk of a last-minute cancellation without consequence.
• For lenders: Ongoing escrow for taxes and insurance lowers the risk of tax liens, lapses in insurance coverage, and other issues that could harm the property's value.

Costs, Fees, and Common Tradeoffs with Escrow Accounts

Escrow reduces risk, but it also has costs and tradeoffs that matter when you compare loans, evaluate closing disclosures, or budget for homeownership.

Typical escrow-related costs at closing

At the time you buy a property or refinance, you will often see several escrow-related line items on your closing documents:

• Initial escrow deposit: A lump sum paid at closing to "seed" the escrow account so that enough funds are available for the first tax and insurance payments. This amount depends on the timing of your closing relative to when those bills are due.
• Prepaid taxes and insurance: In some transactions, a portion of upcoming property tax or insurance bills may be collected at closing, so you effectively pay some of these costs in advance.
• Escrow service or settlement fee: In a purchase transaction, the escrow company or closing agent may charge a separate fee for managing the closing, holding funds, and recording documents. This can be a flat fee or a fee that varies by transaction size and local customs.

Ongoing costs, cushions, and how they affect your payment

Once your mortgage is in place, escrow influences what you pay each month.

• Monthly escrow contribution: Your lender divides the estimated yearly total for property taxes and insurance by 12. That amount is built into your monthly mortgage payment in addition to principal and interest.
• Escrow cushion or reserve: Many servicers maintain a small reserve in the escrow account to cover unexpected increases in taxes or insurance. This cushion is often limited by regulation but can still affect how much you need to pay in the early years.
• Adjustments for shortages or surpluses: If the account ends up short because costs rose faster than expected, your servicer may increase your monthly escrow portion, request an additional lump-sum payment, or both. If there is a surplus above the allowed cushion, you may receive a refund or a reduction in your future payments.

Pros and cons of using escrow for taxes and insurance

When you analyze escrow from a costs and fees perspective, it helps to weigh the tradeoffs clearly.

• Advantages:
  • Spreads large, infrequent bills over 12 months, which can make budgeting easier.
  • Reduces the risk of missed or late tax and insurance payments, which can carry penalties or coverage gaps.
  • Some buyers find that having the lender manage these payments gives peace of mind, even if it slightly increases monthly costs.
• Drawbacks:
  • Your monthly payment is higher than it would be without escrow, because it includes taxes and insurance in addition to principal and interest.
  • You rely on the servicer's estimates. If estimates are off, you can face payment changes and unexpected escrow shortages.
  • In some situations you may prefer to hold and manage the funds yourself rather than keeping extra money in an account controlled by your servicer.

From a costs and fees standpoint, the key is to understand what you will pay at closing to set up escrow, how your monthly payment is built, and how changes in taxes or insurance will flow through to your budget over time.