Escrow in Mortgage: How It Works and Why You Need It

When you’re buying a home with a mortgage, an escrow account is often included to help with the handling of related expenses, such as property tax and home insurance. Whereas having a steady monthly payment throughout your mortgage might be what you prefer, you should be prepared for the amount to fluctuate. What happens if your escrow payment changes?

Many things can go wrong in a mortgage arrangement. If you fail to pay the property tax, you could lose your home to tax lien foreclosure. That would be a loss not only to you, but also the mortgage lender. Damage to your property because of hurricanes or other destructive events can also result in losses to you and the lender.

When striking a mortgage deal, lenders take these factors into consideration to avoid problems down the road. They’ll set up a special escrow account to hold money for property tax and home insurance premium payments.

When you make the monthly mortgage payments, a portion of the money goes into repaying the loan and another into the escrow account. As the tax and insurance bills become due, the mortgage servicer takes money from the escrow account and settles these expenses on your behalf.

Your monthly mortgage payment amount will be higher if an escrow account is included. However, including escrow can avoid problems. First, you can rest assured that property tax and insurance premiums will be paid on time, saving you from late payment fees or even a tax lien on your house. Additionally, having an escrow account makes it easier to manage property tax payments—instead of having to deal with one large bill each year, you make small monthly payments.

The money that goes into an escrow account is the lender’s estimate of what the property tax and home insurance will cost. These expenses can fluctuate, resulting in a shortfall in the escrow account if expenses rise and a surplus if expenses decline.

The lender conducts an annual review of the escrow account to determine its standing. If there's a shortfall because property taxes or insurance premiums have increased, the lender will need you to put more money into the account. Otherwise, the lender may raise your monthly mortgage payment amount to collect more escrow money. On the other hand, you may get a refund if the escrow account is in surplus, or the lender may put the surplus amount toward reducing your mortgage.

Bear in mind that the mortgage lender may require that you deposit three months’ worth of property tax into the escrow account when closing a mortgage deal. In some cases, an escrow cushion may be required to ensure that unexpected expenses, such as spikes in taxes or insurance premiums, are handled smoothly.