What is an Escrow Account and How Does it Work?

When you purchase a home, you may be required to set up an escrow account. This account is used to hold funds for taxes, insurance, and other expenses related to owning a home. The growth of online shopping has led to an increased use of the escrow process to protect buyers and sellers. In this article, we'll explain what an escrow account is and how it works.

An escrow account is a financial arrangement where a third party holds and regulates payment of the funds required for two parties involved in a given transaction. It helps make transactions more secure by keeping the payment in a secure escrow account which is only released when all of the terms of an agreement are met as overseen by the escrow company. When you make your full monthly payment, part goes to your mortgage to pay principal and interest, and another part goes to your escrow account to pay your taxes, property insurance and other expenses you may have when you own a home, such as mortgage insurance and insurance against floods. If you have enough savings to buy a home without a loan or pay the mortgage with your own money, you can do without the higher costs of an escrow.

Mortgage holders are required to send you an annual statement regarding the activity of their escrow account, which may also be referred to as a mortgage seizure account. Instead of paying taxes directly to the government and insurance premiums to the insurer, an FHA borrower pays one-twelfth of these expenses each month, in addition to paying mortgage capital and interest, into the account. The escrow agent is usually the same as the title agent who keeps the deed until the sale is closed during the homebuying process. Your escrow account will cover regular property taxes and homeowners insurance, as well as flood insurance if needed in your area. Once you agree on the price of the home with the seller, your agent will charge you the collateral (a bona-fide deposit that shows that you are serious about buying the home) and will deposit it in an escrow account.

Your real estate agent will oversee this entire escrow process, so don't worry too much if you don't understand all the details. A renter's escrow account allows you to pay the rent to a third party to give it to the landlord when necessary repairs are made or when working appliances are installed. Each year, the mortgage servicer will review your account to ensure that you are paying the right amount to maintain the required minimum balance. Banks generally use the loan-to-value ratio (LTV) to determine if their home loan will require an escrow account, and borrowers whose mortgage amount represents 80% or less of the value of the home can generally avoid the security deposit if they so choose. The cost of security deposit fees will depend on the escrow company you use and the location of the home, but they usually represent between one and two percent of the purchase price. However, many home buyers and sellers can't answer the question “what is the security deposit? or explain how it works. Escrow accounts are useful in any situation where two parties want protection until the agreed terms are met.

When buying a home, your mortgage lender may require an escrow account to hold the funds needed to close until the deal is closed. Your lender may require a “security cushion”, as allowed by state law, to cover unforeseen costs, such as a tax increase.