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What Is Escrow and How Does It Work?

Escrow accounts allow buyers to reserve money for property tax and insurance bills. They’re also used in the mortgage process to hold earnest money until closing day.

Aly J. Yale Aly J. Yale Edited by Chris Jennings Updated January 4, 2022

What is escrow hero

Our goal is to give you the tools and confidence you need to improve your finances. Although we receive compensation from our partner lenders, whom we will always identify, all opinions are our own. By refinancing your mortgage, total finance charges may be higher over the life of the loan.
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Escrow is a type of account used to stow money for an upcoming home purchase. It can also be used for future property taxes and insurance costs on a home you already own. Depending on your lender, you could use an escrow account both upfront and over the entire course of your loan.

Here’s what you need to know about escrow:

  • What is escrow?
  • How does escrow work?
  • Escrow types
  • What escrow accounts do
  • What escrow doesn’t cover
  • Pros and cons of escrow
  • Escrow example
  • What is an escrow fee?
  • How long do you pay escrow?
  • Are escrow accounts required?

What is escrow?

A buyer and seller may create an escrow account with a neutral third party to pay for certain expenses and avoid payment disputes.

For example, in real estate transactions, escrow agents collect earnest money and deposit it into an escrow account until closing.

How does escrow work?

Escrow works in one of two ways:

  1. To hold funds, such as an earnest money deposit, during a real estate transaction.
  2. To hold funds owed for annual housing expenses, such as property taxes.

During a real estate transaction, escrow provides financial protection for the buyer and seller should the transaction fall through. The purchase agreement states how much your monthly escrow payments will be and when the escrow company will disburse the funds.

Your monthly escrow payment to your mortgage lender will cover a portion of your:

  • Property taxes
  • Homeowners insurance
  • Other insurance premiums (such as flood insurance)
  • Mortgage insurance (if applicable)

When it comes time to pay your tax and insurance bills, your mortgage lender will pull the funds from the escrow account and pay the bills for you.

Learn: 30 Mortgage Terms to Know: Ultimate Glossary for Homebuyers

Escrow types

Most people associate escrow payments with a mortgage, but there are a few other situations where escrow may apply.

Real estate

Whether you buy a home with cash or a mortgage, most real estate transactions involve an escrow service to finalize the sale.

During the homebuying process, the seller usually uses a title company or an attorney to collect earnest money from the buyer and hold it in an escrow account until closing. Your real estate agent may also recommend an escrow service.

Why escrow matters in real estate transactions: Escrow can protect the buyer if, for example, the home inspection or appraisal value is unfavorable and you decide to back out of the deal.

If you have certain contingencies in place that aren’t met, you might be able to receive your earnest money deposit back from the escrow provider instead of hoping the seller will refund the true amount.

Likewise, escrow helps ensure the seller receives the earnest money if the buyer backs out of the deal after certain deadlines have passed.

Taxes and insurance

Most mortgage lenders require monthly escrow payments to cover property taxes, homeowners insurance, and private mortgage insurance.

Your mortgage servicer estimates the annual cost of your expenses requiring escrow, and you pay a one-twelfth of the total amount each month. For example, an annual $1,200 insurance premium would require a $100 payment.

Your escrow agent disburses the funds annually when the appropriate bill comes due. After you pay off your mortgage deed, you receive any excess balance as a refund.

Stock

Investors and company executives may receive escrowed shares during mergers and acquisitions as an incentive to remain a shareholder during the transition.

You cannot sell the shares while they are in the escrow account. However, you can sell them once the shares settle and exit escrow.

Online sales

Online marketplaces may hold funds in escrow for the buyer and seller. For example, the buyer pays for the purchase in full but the seller won’t receive the proceeds until the item is delivered.

Cross-border transactions and freelance platforms may also use escrow accounts.

Security deposits

You may also need to make a refundable security deposit in escrow for services like staying at a vacation home, renting an apartment, or signing up for utilities.

What escrow accounts do

Escrow accounts have two different functions depending on when they come into play.

Before closing: Hold your earnest money

Once you find a home and put in an offer, you’ll give the seller what’s called an earnest money deposit. This is a good faith payment — one the seller gets to keep if you back out of the deal or violate your contract. An earnest money deposit typically amounts to 1% to 3% the home’s price.

If the seller accepts your offer, that earnest money deposit will be held in an escrow account for safekeeping until you either close on the home or back out of the transaction. If you do close on the home, the money will go toward your closing costs.

Good to know: In some cases, the money in escrow will be withheld at closing — called an escrow holdback — if the sellers have agreed to certain repairs. Once those repairs are completed, they’ll then get the remaining escrow balance as agreed.

Escrow costs are just one of the many expenses you’ll face as a homebuyer. To lower your overall monthly expenses, make sure to shop around for great mortgage rates. You can find prequalified rates easily with Credible — and it only takes a few minutes.

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After closing: Pay taxes and insurance

Another type of escrow you may encounter is “reverse account escrow.” This escrow comes into play after your home purchase is complete — and in perpetuity while you own the property.

Put simply, these escrow accounts are used to store a portion of your monthly mortgage payments. Once your property taxes and homeowners insurance premiums come due, your loan servicer will use the account balance to pay them off.

After you apply for a mortgage, your lender should give you a loan estimate that breaks down the four portions of your monthly payment: principal, interest, taxes, and insurance. This will give you an idea of how much will be withheld for escrow and how much will go toward paying off your loan each month.

Keep in mind: Property taxes can change annually, as can your insurance premium. Your servicer will likely perform an annual escrow analysis to be sure they’re withholding enough money to continue paying these bills.

If the analysis shows they’re short — or could be close to it — they may increase how much you pay into escrow each month. This would mean a higher monthly payment, too. (If the analysis shows they’re over-funding your escrow account, you could get a refund!)

Learn More: How to Lower Your Monthly Mortgage Payment

What escrow doesn’t cover

Escrow can be a handy tool in planning for the larger costs of homeownership. But be careful — it won’t cover everything.

Here are just a few expenses your escrow account won’t pay for:

  • Utility bills: Bills from your electric or water company won’t be covered by your escrow account. Taxes from your local utility district might, though.
  • HOA fees: Your escrow account typically won’t cover any HOA, POA, or community-based dues. If you get a bill for these, make sure to pay it by the deadline to avoid any penalties.
  • Supplemental tax bills: This includes taxes that go beyond your traditional property taxes. They may be taxes on a new home addition or additional charges due to a change in home value. Usually, these aren’t covered by escrow either.

There are many other costs of homeownership to think about, too. Take a look below to see what’s covered by escrow.

ExpenseCovered by escrow?
Property taxYes
Homeowners insurance premiumsYes
Earnest money depositYes
Utility billsNo
HOA duesNo
Supplemental taxesNo
Down paymentNo
Closing costsNo

Pros and cons of escrow

Here are the advantages and disadvantages of escrow payments.

Pros of escrow

  • Protects buyers and sellers: Unfortunately, not every home sale goes through after the seller accepts the buyer’s initial purchase offer. An escrow account tracks every transaction and ensures both parties receive fair treatment.
  • Budget for ongoing costs: Monthly escrow payments make it easier to budget for annual property tax and insurance bills.
  • Ensure bills are paid on time: By keeping your tax and insurance funds in an escrow account, you won’t have to worry about payment deadlines. Your mortgage lender will automatically pull the funds from the escrow account and pay each bill on your behalf.
  • May earn interest: Your escrow balance may earn interest in certain states. The amount earned varies by bank and state.

Cons of escrow

  • Higher monthly payment: Your mortgage payment might be higher than the payment on your loan estimate, which may only calculate your principal and interest costs. Keep property taxes and insurance costs in mind when shopping for a home.
  • Fluctuating payments: Escrow holders perform an annual analysis of the projected costs for the next 12 months. As a result, your monthly escrow payment may increase or decrease several times during the loan’s repayment period, which might make it harder for you to budget housing costs.
  • Incorrect payments: Your escrow company may forecast an inaccurate payment amount. If this happens, you may need to make a lump-sum payment to avoid an escrow shortage. If you’re overpaying, though, you might receive a partial refund.
  • Upfront deposit: Most lenders require at least two months of escrow payments upfront at closing. This deposit is in addition to your down payment and closing costs.

Escrow example

When buying a home, you’ll likely make an earnest money deposit into an escrow account. This deposit is usually between 1% to 3% of the purchase price, but can be higher in some cases. So, on a $350,000 home, you can expect to put down at least $3,500 (1%) with your offer, in addition to your down payment.

Monthly escrow payment example: Let’s say you have a monthly homeowners insurance premium of $150 and a monthly property tax bill of $200.

This gives you a monthly escrow payment of $350. At closing, your lender will likely require you to pay two months of escrow reserves upfront — in this case, $700.

Also, keep in mind that your monthly escrow payment may adjust as your taxes and insurance premiums change. However, if you have a fixed interest rate, your mortgage payment will remain the same.

What is an escrow fee?

Escrow fees can vary based on your location and escrow company, but you can expect to pay between 1% to 2% of the purchase price.

Depending on the purchase agreement, either party may pay the entire cost or split the expense.

How long do you pay escrow?

Most mortgage lenders require paying escrow for the life of your loan. If you have private mortgage insurance premiums, you can request to cancel those payments once you reach 20% equity.

Tip: You may be able to cancel your escrow account early and lower your monthly mortgage payment once your mortgage is at least a year old. If you’re comfortable paying your own insurance and taxes, contact your servicer to see if you qualify.

Are escrow accounts required?

Most home loans come with escrow requirements. Though these will make your monthly payment higher nominally, they really just spread the cost of your taxes and insurance out over time.

They also prevent you from falling behind on your payment deadlines and eliminate some of the hassle that comes with homeownership (you don’t have to keep track of those deadlines by yourself).

If you’re shopping around for a home loan, be sure to compare multiple lenders before settling on a rate. Credible streamlines the home loan process and makes comparing multiple lenders easy — you can see your prequalified rates from our partner lenders in the table below in just a few minutes.

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Josh Patoka contributed to the reporting for this article.

About the author
Aly J. Yale
Aly J. Yale

Aly J. Yale is a mortgage and real estate authority. Her work has appeared in Forbes, Fox Business, The Motley Fool, Bankrate, The Balance, and more.

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