Escrow accounts are a form of savings account routinely used both during and after the real estate purchase process. Consumers don’t typically shop for their own escrow account. Instead, escrow accounts are established by a lender. They’re used as deposit accounts for earnest money when you purchase a home, and in most cases, an escrow account is required by your mortgage lender as a holding account for home expenses such as property taxes and insurance.Recent CoreLogic research indicates that 80% of U.S. mortgage borrowers use loans featuring escrow accounts. According to CoreLogic, lenders and loan servicers prefer to see escrow accounts established because they provide assurance that funds for the variable “taxes and insurance” portion of “principal, interest, taxes and insurance,” or PITI, are set aside.

What are the basics of an escrow account?

When you make an offer on a home, your earnest money for the purchase goes into an escrow account for future disbursement to the seller (assuming the transaction proceeds). This type of escrow account is short-lived and transaction-related.

When you purchase a home backed by the Federal Housing Administration (FHA), a portion of the funds you borrowed will automatically be set aside by your loan servicer in an escrow account from which your lender will pay your insurance and property taxes. Lenders underwriting non-FHA loans may choose whether to require escrow accounts for borrowers based on a variety of factors including down payment size and credit score. Lenders must disclose in a “good faith estimate” document provided to borrowers whether the loan they’re offering includes or excludes an escrow account and what portion of funds involved in the initial home transaction will initially fund the account.

Escrow covers the aspects of a housing payment beyond mortgage principal and interest that concern lenders — taxes and insurance. Taxes may include city, county or other special local taxes. Insurance can include property insurance, hazard insurance, supplemental insurance (earthquake, flood zone, etc.) and mortgage insurance.

Escrow doesn’t cover utility payments or payments related to home repair, maintenance or improvement. When you close on the purchase of your home, you will receive an escrow statement as part of your closing documents. The Consumer Finance Protection Bureau (CFPB) provides this example.

Determining escrow payments

Escrow payments are estimated annually by your lender. Using annually established property taxes and applicable insurance premiums, lenders will take the yearly total of these figures and divide it by 12, then wrap the result into your single monthly housing payment. When you pay your mortgage, the portion for insurance and taxes will go into your escrow account and the lender will use escrowed funds to pay those bills on time.

Lenders must conduct what’s known as a yearly escrow analysis in order to make sure you’re paying enough into the account for the lender to disburse adequately to taxing authorities and insurers. The amount of funds required in your escrow account can shift from one year to the next. This is because insurance rates for an existing policy can rise, or you may choose to pay more for increased coverage, and real estate taxes typically rise slightly over time due to local levies or shifting property values.

Freddie Mac reminds borrowers that escrow accounts use estimates to project the coming year’s expenses, which means escrow accounts may need adjusting after a lender’s analysis. If your account shows a shortage or deficiency, a lender may choose to do nothing about it, provide you with 30 days to pay the shortage amount, or let you spread payments over the coming 12 months in the form of a small increase to your mortgage payment.

If a shortage exceeds the average monthly payment, the lender must let you spread payments over 12 months rather than force you to make the entire payment immediately. If an escrow account shows an overage of $50 or more, your lender must send you a check for the amount within 30 days of the escrow analysis, otherwise, the lender can apply the excess funding toward the coming year’s expenses.

How much can my lender keep in escrow?

Under the Real Estate Settlement Procedures Act (RESPA), loans that require escrow accounts will calculate escrow as part of closing documents. Borrowers whose lender requires escrow will pay a flat fee to their mortgage lender each month, a portion of which will go toward funding the borrower’s escrow account. Their mortgage bill will explain what portion of their payment covers principal, interest and escrow for taxes and insurance. From there, the lender is responsible for paying the borrower’s insurance and taxes out of escrow.

Loans that don’t require escrow accounts as a condition of closing, where the borrower will establish their own escrow account, require the loan servicer to provide the borrower with a statement of escrowed expenses within 45 calendar days of closing. Generally, these expenses include insurance and taxes.

A loan servicer may ask a borrower to pay 1/12 of the total annual escrow payments it estimates it will pay out of the account. Additionally, a loan servicer may require payments from the borrower so that the account has a cushion. A cushion allows the lender to have coverage for payments that are not monthly but, perhaps, quarterly or semiannual.

Lenders may keep no more than 1/6 of the total annual cost of escrow-paid items in an escrow account. For example, if a home’s property taxes are $4,000 per year and its insurance is $800, then the annual amount in escrow should be $4,800. This means that an escrow account can’t keep more than an $800 (1/6 of $4,800) as a “cushion” in the account. A cushion is not counted as an overage.

Can you avoid an escrow account?

FHA borrowers, who constitute a large percentage of first-time buyers, cannot avoid escrow accounts. Borrowers using other loan types may pursue an escrow waiver. Typically, to secure an escrow waiver, you must use a loan with at least a 20% down payment (known as 80% loan-to-value, or LTV) and you may also need to pay points fees on your loan. Some lenders in 2018 began experimenting with waiving escrow on loans with down payments as low as 5%. Points for escrow origination generally cost $250 per $100,000 borrowed.

Fannie Mae states that it discourages lenders from using LTV alone as the basis for waiving escrow. The government-backed agency also states that any lender permitting waivers must have a stated policy detailing what circumstances must be satisfied for a waiver to be granted.

Because an escrow waiver will require that you as borrower keep track of making timely and often large lump-sum payments for property taxes and insurance, proof of financial responsibility in some form — a high credit score, strong cash reserves — may also contribute to a lender’s decision to grant or deny an escrow waiver.

Escrow accounts let homeowners spread routine yet important housing costs across the monthly payments they make throughout the year, and they make the lender responsible for timely payments to taxing and insurance authorities (and for any fees should the lender make mistakes).

The financial savings possible from forgoing an escrow account and managing tax and insurance bills yourself is negligible, but avoiding escrow may nonetheless appeal to some buyers who have the resources and organizational skills to manage these bills on time, themselves.