Homebuying 101: What is an Escrow Account?

Welcome back to Homebuying 101! With an overwhelming amount of new terms and phrases to learn in a short amount of time, it can be hard to keep track of it all. That's where we come in! Today's topic: escrow accounts. What are they, and why are they beneficial to homebuyers?

What You Need to Know

An escrow account is typically used for two reasons-- to protect a homebuyer's "good faith" deposit before the transaction closes and afterward, to hold the homeowner's funds for taxes and insurance. The homebuyer can create an escrow account, but the buyer's real estate agent will typically be the one to open this account.

HELPFUL INFO: During the homebuying transaction, the account may be managed by a specialized company or agent; your escrow company and title company may be the same.

How it Works

Let's say you find your dream house and put down an earnest money deposit to let the seller know you're interested. This deposit doesn't go straight to the seller's pockets. Instead, these funds are deposited into an escrow account. When your housing transaction closes, the money is then put toward your down payment and closing costs.

Once you become a homeowner, you will fund the escrow each month as part of your total monthly mortgage payment. When you make a mortgage payment through your loan servicer, the money will be distributed among multiple categories, such as:

• Principal and interest on your mortgage
• Property taxes
• Homeowners insurance
• Mortgage insurance

Items not covered through your escrow account:

• Utilities and other bills
• Necessary home repairs
• HOA fees

Is an Escrow Account Required?

The short answer is, it depends. Some loans will require an escrow account to be set up as an additional safety net for the lender, such as an FHA loan. Regardless of whether your state, lender, or loan requires an escrow account, it's beneficial to have one in place.

Making Payments from Year-to-Year

Each year, your bank receives updated information on your property taxes and insurance payments. They will then perform what's often referred to as an escrow analysis.

Because escrow is collected in advance, your lender might not have enough funds in your account to cover any increase in taxes or insurance, otherwise known as a "shortage." In this case, you will owe the difference. However, you won't be held responsible for this payment until the bank sends you a notice stating the amount outstanding.

Once you receive the notice, you can choose to pay the entire shortage as one lump sum, or you can choose to pay the amount over the next year. For example, if the shortage is $500, you will pay 1/12 of this amount each month.

In the Event of a Surplus

If taxes in your area happen to go down or your payments are overestimated, you will have too much money in your escrow account at the end of the year. Your lender will then pay the appropriate amount to the municipality, and the remaining amount goes to you.

Your lender will either send you a check for the surplus amount or give you the option to leave the money in your escrow account in case of a shortage in the upcoming year.

Budgeting for the Future

Anticipating whether or not you'll be required to pay more on your escrow account can be hard to keep track of. If you prefer to plan ahead, pay attention to any correspondence from your insurance company or taxing authority throughout the year, and budget accordingly.

Questions? We can help! Talk to a Mortgage Advisor today for a no-commitment consolation.