- Escrow is an arrangement of a third party holding money in an account to protect both the buyer and seller.
- You'll keep an earnest money deposit toward your down payment in an escrow account until you close.
- You'll likely also have an escrow account when you own the home to pay your taxes and insurance.
Buying a home is often the biggest transaction a person makes, and it involves a lot of money changing hands. To make sure everyone gets what they're owed, the money being transferred from buyer to seller is typically held in an escrow account.
What is escrow, and how does escrow work when buying a home? Here's what homebuyers and sellers need to know.
What is an escrow account? Escrow account definition
Escrow is the legal process of a third party holding money or other assets in an account until all the parties in a transaction meet certain requirements. These accounts are known as "escrow accounts."
Escrow process explained
During the homebuying process, large sums of money need to be transferred between the buyer and the seller. Escrow ensures that everyone gets their money, but not before certain conditions are met.
One of the main uses of an escrow account during this process is to hold onto the buyer's earnest money deposit. Once the contract to purchase the home is signed, the buyer puts their earnest money deposit in an escrow account. This money protects the seller in case the buyer decides to back out of the transaction for reasons not stipulated in the contract.
If all goes according to plan, the earnest money deposit will be paid out to the seller after closing as part of the buyer's down payment.
Escrow vs. closing
Once you've signed a purchase agreement, multiple parties, including your mortgage lender and your real estate agent, get to work preparing the transaction for your closing date, or the date you'll take ownership of the home. This is often referred to as the closing process.
Escrow is a part of this process. Your earnest money deposit will remain in your escrow account until you've closed on the home, at which point it will be sent to the seller.
Types of escrow accounts and how they work
There are two types of escrow accounts. You'll use one in the homebuying process and the other after you've bought the home.
1. Escrow account for buying a home
As part of the closing process, you'll put your earnest money deposit in an escrow account. This money is usually between 1% to 3% of the home purchase price, or $1,000 to $3,000 for every $100,000.
What if you don't end up buying the house? If you back out for reasons allowed by your contract, like a low appraisal or problematic home inspection, you'll probably be able to keep the money. But if you're far along in the process and decide to back out because you aren't interested anymore, the seller may be able to keep your earnest money.
2. Escrow account for taxes and insurance
When you get a mortgage, your monthly mortgage payment is made up of a few different parts:
- Principal.This is the amount you initially borrowed.
- Interest.This is what the lender charges for giving you money. A mortgage calculatorcan tell you how much your principal and interest will cost you on a monthly basis.
- Taxes.Homeowners must pay property taxes, which are often due twice a year, depending on where you live.
- Insurance. Your mortgage lender will require you to have a homeowners insurance policy, and depending on how much equity you have in your home, you may also need to pay for mortgage insurance.
Even though taxes and insurance aren't owed to your lender, they still have a vested interest in making sure you pay these costs. So, they'll often pay it for you through an escrow account.
The monthly cost of your taxes and insurance is factored into your monthly mortgage payment, and they're credited toward your escrow account every time you make a payment. Then, when your insurance premium or tax bill is due, the lender pays it on your behalf from the funds in your account.
As part of your closing costs, you'll prepay a portion of your future homeowners insurance premium and property taxes into your escrow account.
Your tax and insurance expenses can change over time. If the lender realizes it's charged you too much, you'll receive a refund. If you haven't paid enough, you'll need to cover what's left.
Do you need escrow accounts when you get a mortgage?
Most types of mortgages require you to have an escrow account for your insurance and tax payments, but not all. Here are the rules for each type of mortgage:
- Conventional mortgages: This can depend on your lender, the exact type of loan you have, and the details of your particular situation. If you're a riskier borrower (for example, if you make a small down payment), you might not be able to avoid an escrow account. But if you meet your lender's requirements, you may be able to get an escrow waiver, which means you won't have your taxes and insurance included in your mortgage payment.
- FHA mortgages: An escrow account is required.
- VA mortgages: It depends — there's no law stating that VA loans require escrow accounts, but many VA lenders require them.
- USDA mortgages: Yes, you'll need an escrow account.
How long do you pay escrow on a mortgage?
Let's break this down by both types of escrow accounts.
For the escrow account when buying a home (the one that holds your earnest money deposit), you'll probably keep the deposit in the escrow account for around a month or so. That's roughly the length of time between when you make an offer and when you close on a house.
For the escrow account that holds money from your monthly payments, it will depend on your situation. For a conventional mortgage, you may be able to close your escrow account once you have at least 20% equity in your home, which is also how much you'll need to cancel private mortgage insurance.
You can't close an escrow account on an FHA or USDA mortgage. For a VA mortgage, it may depend on your lender.
Ask your lender what their specific requirements are for canceling your escrow account.
Remember that you'll still owe property taxes and insurance even without an escrow account. The difference is that you'll need to budget for these costs on your own to ensure you can pay those bills when they come due.
How much are escrow fees and costs?
As part of your closing costs, you'll pay escrow fees to the company or parties that oversaw the escrow and closing processes. This varies by state, but may be between 1% to 2% of the purchase price. This may be paid by the buyer or seller, or split between the two.
Escrow is often handled by a title company. Your real estate agent or lender may recommend a company to use for the transaction, but you can also shop around for this service to try to save a little money.
Other uses of escrow
Escrow isn't exclusively used for home purchase transactions, but that's when people most commonly encounter it. Any time large sums of money or valuable assets are being exchanged between two parties, an escrow account can facilitate the transaction in a way that protects everyone. Some services even offer escrow for online transactions, to protect your funds when buying or selling items online.
What is an escrow account FAQs
What is the purpose of an escrow account?
When you're closing on a house, escrow holds the funds you owe the seller to make sure all the conditions of the purchase are met. After you've closed, your lender will likely create an escrow account to pay out of once your property taxes or insurance premiums come due.
Who owns the money in an escrow account?
An escrow agent is a neutral third party that holds onto the money in the escrow account until certain conditions are met, after which it will either be paid out to the seller or go back to the buyer, depending on the circumstances.
Can I take money out of my escrow account?
No, you can't withdraw money from your escrow account unless you meet the conditions specified at the creation of the account. If you back out of the sale for a reason allowed by the contract, then you'll get your money in escrow back.
How can I escrow my homeowners insurance?
To escrow your homeowners insurance, you'll need to talk to your lender or mortgage servicer. Once an account is set up, the lender will figure out how much you owe on a monthly basis to pay your full premium when it comes due.
Is an escrow account good or bad?
Escrow accounts have both pros and cons. Some people don't like having an escrow account on their mortgage because they prefer to make tax and insurance payments themselves. But it can also be convenient to have your mortgage lender handle these payments.
What happens to money in an escrow account?
Money in an escrow account is overseen by a neutral third party until certain conditions are met or a payment is due from the account.