What Is Escrow? Everything You Need To Know

Escrow is a legal arrangement where a neutral third party with no interest in a transaction holds something of value. This arrangement is used in multiple ways in real estate transactions. 

Homebuyers deposit earnest money in escrow accounts to show they're serious about a purchase, and lenders use escrow accounts if you're required or choose to prepay certain home expenses as part of each mortgage payment.

You may also hear your real estate agent use the phrase “in escrow” to describe the phase of a real estate transaction when the home purchase agreement has been signed and the contingency period is underway. 

Let’s dive into how escrow works, what escrow payments include, and when they’re required.

What is escrow?

There are three possible meanings of escrow in real estate:

• Escrow account: Also known as an impound account, an escrow account is set up by a real estate broker, escrow agent, or lender and managed by a neutral third-party, such as an attorney or title agent. Escrow accounts hold money for certain closing costs until the home sale is complete. Lenders also use escrow accounts to hold money buyers pay toward property taxes or insurance premiums until these bills are due. 
• In escrow: In escrow describes the phase of a real estate transaction when the buyer and seller have signed the purchase agreement, but the purchase conditions haven't been met yet. Payments related to the transaction are held in an escrow account while the closing process is underway, and the money is released to the seller when the contract is fulfilled. 
• Escrow payments: Lenders may require that you make payments toward your property taxes and homeowners' insurance with each mortgage payment, or you might choose to do so. Those are called escrow payments because they store this money in escrow until the annual bills are due. 

How does escrow work when buying a house?

When you're buying a house, certain steps must be completed before the transaction can close. Typically:

• The seller will provide disclosures about the home. 
• You’ll schedule a home appraisal and inspection.
• You'll secure a mortgage for the property.

Some buyers include contingencies in their contract that allow them to back out of the sale (like if the home inspector discovers major problems or if the home doesn't appraise for the sale price). 

While the process of meeting the contingencies is ongoing, your earnest money deposit is held in an escrow account managed by a neutral third party. That ensures your cash is secure and the seller can’t keep the funds if the conditions for the sale aren't met. It also protects the seller because you forfeit the money if you walk away from the deal without justification. 

“Picture a lockbox that nobody owns until the deal closes,” explains Erik Leland, Lake Oswego, Oregon area real estate broker at Realty First. “The buyer wires the money, the seller signs disclosures, and the title company holds everything. Nobody touches the money until every condition checks out: inspections, appraisal, loan approval, title search.” 

An escrow officer checks that all contingencies are met or waived within a certain timeframe, and Leland says escrow keeps both sides honest because the funds aren’t released until everything is complete. 

What does an escrow payment include?

Escrow payments are different from escrow during the home sale. Escrow payments are made toward certain expenses each time you make a mortgage payment. Depending on your property and lender, your escrow payment may include money to cover:

• Property taxes
• Home insurance premiums
• Mortgage insurance premiums for FHA loans
• Private mortgage insurance for conventional mortgages
• Municipal fees
• Flood insurance 

Your lender collects this money each month and deposits it in an escrow account to make sure it's available and ready when insurance premiums, tax payments, or fees come due. 

How long do you pay escrow on a mortgage?

In some cases, you may be required to pay escrow for the full mortgage term — like if you have an FHA loan or flood insurance. However, depending on your lender's policies and the type of mortgage loan you have, you’re generally eligible to request an escrow waiver once your outstanding loan balance is less than 80% of your home’s original appraised value, as long as your mortgage is in good standing. 

Your lender or loan servicer will inform you of the escrow requirements and under what conditions you’re allowed to discontinue payments.

Why do lenders require escrow accounts?

While there's no law that lenders require escrow payments, some lenders impose them to ensure your property tax and insurance payments remain up-to-date. 

“Lenders do not like getting burned. Their whole business revolves around risk management and measured risk,” explains Leland. “When a bank loans you $800K, the house is their collateral. If you forget to pay property taxes, the county puts a lien on the house that jumps ahead of the mortgage. If you let insurance lapse and the house burns down, the bank only has a fraction of the value as collateral.” 

Requiring escrow payments is a way to mitigate those risks, as well as the risk of payments rising and causing you to fall short. 

“Lenders require that customers keep a cushion, usually two months' worth of payments, in escrow to account for potential increases,” says Jack Miller, direct lender and strategic financing advisor at Real Estate Bees. 

Is escrow required for all loan types?

Escrow isn’t required for all loan types. Certain loan programs, like FHA-backed mortgage loans, require escrow accounts. Federal law also requires escrow payments for certain properties, including those located in flood hazard zones, for mortgages issued in 2016 or later. 

For conventional mortgages, escrow requirements vary by lender and by factors like your down payment amount. If your mortgage requires escrow payments, your lender must abide by the Real Estate Settlement Procedure Act (RESPA), which protects consumers from excessive charges and deceptive practices. 

If your lender doesn’t require escrow, you may want to request it voluntarily, especially if your property-related expenses are high. “Anyone who struggles with lump-sum budgeting should keep escrow voluntarily,” says Leland. 

Otherwise, you could end up relying on high-interest credit cards when your tax bill is due. 

Requirements for cancelling escrow on a mortgage

Requirements for cancelling escrow vary by lender and state law. You can check your mortgage agreement or ask your lender or loan servicer if you’re eligible to request an escrow waiver. 

“Most lenders want 20% equity or above and a perfect payment history for one to two years,” says Leland. “You have to request the release in writing, and some charge a small fee.” Some lenders also impose a waiting period or have minimum credit score requirements for cancelling escrow.

Bear in mind, some loans may not be eligible for an escrow waiver, including certain government-backed loans and mortgages secured by properties in high-risk flood hazard areas. And, even if you qualify to remove escrow from your mortgage, you should consider the decision carefully. 

“Removing escrow from the mortgage may be tempting to reduce a buyer's monthly mortgage payment, but it also shifts the responsibility of paying taxes and insurance onto the buyer. Homeowners should deeply consider how large and how unpredictable these payments could be,” says Miller. “Property taxes and homeowner insurance premiums could regularly increase over the years. A homeowner who  fails to make these payments can incur penalties and risk liens being placed on their home.”

Pros and cons of removing escrow from your mortgage

Details on the pros

• Lower monthly payments: Removing escrow from your mortgage reduces your monthly payments, providing more wiggle room in your monthly budget. However, you’ll still be responsible for all property-related expenses when your bills are due.
• Budget flexibility: Money held in an escrow account isn’t generally accessible to you. But if you remove escrow and save the money for bills in your own account, you can borrow from it for unexpected expenses. Just be sure you’ll have enough when taxes and premiums are due. 
• Interest earnings: Some states require that servicers pay interest on the funds held in an escrow account, but the interest rate is typically much lower than savings account rates. If you remove escrow from your mortgage and save for lump-sum payments on your own, you can keep that money in a high-yield savings account and earn interest on it until your payments are due. 

Details on the cons

• Requires discipline: Maintaining escrow for taxes and insurance keeps these costly expenses manageable. If you remove escrow from your mortgage, you’ll need the discipline to set aside a portion of your income each month to ensure you can pay these bills when they’re due. 
• No “grace period” for rate hikes: Insurance rate hikes can throw a wrench in your budget. “Escrow does not stop rate hikes,” says Leland. “But it acts as a shock absorber. With escrow, the lender pays the new, higher bill in full to prevent a lapse. They then spread that shortage across your next 12 payments. You get a 12-month runway to adjust your budget.” Without this grace period, surprise insurance premium increases could lead to a coverage gap if you can't pay the bill — and an even higher penalty premium because of it. 
• It’s more work: Making escrow payments with your monthly mortgage payment bundles multiple annual expenses into one. If you request an escrow waiver, you’ll need to keep track of payment deadlines for property taxes, home insurance premiums, and any other fees that were included in your escrow payment. 

What is an escrow shortage or surplus?

Many lenders require you to maintain a cushion in your escrow account in case of unexpected increases in tax or insurance costs. However, the law limits the extra to a maximum of one-sixth of your annual escrow expenses for the year. 

In some cases, the lender or loan servicer may overestimate how much money is needed to cover your bills. Each year, the lender or loan servicer must perform an escrow analysis to ensure that your escrow payments align with your actual expenses. 

If the analysis identifies a shortage, your payments weren’t large enough to cover your taxes, insurance, and other bills. The lender can charge you more to make up for the shortage. You’ll typically have the option to pay the shortage in full or spread the amount over 12 monthly payments. 

If the analysis identifies a surplus, you paid more than necessary to cover your bills. If your escrow account has a surplus greater than $50, your lender or loan servicer is required by law to refund the money to you.