What Is A Mortgage Escrow Account And How Does It Work With My Homeowners Insurance Policy?

Feb 14, 2021 | Personal Insurance

Escrow and escrow accounts are two different ideas when mortgages are being talked about. You must be wondering if it’s something you would need at all, right?

First things first

First, escrow is the process in which a neutral third party acts as a real estate dealer who is handling both the money and property “in escrow” until two sides of the party agree that all circumstances are met in order for a sale to be considered as sold. The second point, an escrow account is basically an account that manages a mortgage, a borrower’s yearly tax and insurance expenses.

What is an Escrow Account?

Escrow is a legal concept. This describes a financial instrument wherein an asset or escrow money is handled by a third party on behalf of the other two parties that are in the process of completing a certain transaction. These escrow accounts might also have escrow fees that are managed by agents who handle the funds of assets up until obtaining the right instructions or until the fulfillment of predetermined contractual obligations. Some of the things you can handle in an escrow account are money, securities, funds, and other assets. A similar kind of process would be a fully funded documented letter or credit. This is often suggested as a replacement for a certified or cashier’s check.

You have to have an escrow account that acts as a saving account when you have a mortgage. This is managed by your mortgage servicer. It’s a simple process. He will deposit a part of each mortgage payment into your escrow account to cover your property taxes and insurance premiums.

Basics

Escrow are third-party services that are usually required when purchasing a house. Both the buyer and seller of a house will select a neutral third party to act as the escrow agent when they arrive at a purchase agreement. The escrow agent will then collect the “earnest money” from the buyer of the house. This is a deposit that is equivalent to a small percentage of the sale price. In return, the seller will remove the property from the market. Both the buyer’s deposit and the seller’s property are in escrow until the final exchange has been finally done.

You have to know that escrow “accounts” are more on your mortgage payment than your initial home purchase. You’ll basically be given an escrow account when you borrow money from a bank or a direct mortgage lender. These called escrow accounts are where the lender will deposit the part of your monthly mortgage payment that will cover your taxes and insurance premiums. Furthermore, the escrow account actually decreases the risk that you’ll fail on your obligations to the government or your insurance provider. So, it is best that they collect a part of those yearly expenses each month.

Key points:

  • Obtaining an escrow account is the use of a third party that then holds an asset or funds before they are transferred from one party to another party.
  • The third-party handles the funds until the two parties have fulfilled their contractual requirements.
  • Escrow is often associated with real estate transactions. However, it can apply to any kind of situation where funds will pass from one party to another.

Understanding Escrow

Escrow is a process used when two different parties are in the process of completing a certain transaction and this is also to ensure that the other party will be able to fulfill their obligations. Certain contexts that use escrow include internet transactions, banking, intellectual property, real estate, mergers and acquisitions, law, etc.

One example you may consider is that a company that is selling their goods internationally. That certain company requires assurance that it will receive payment when the goods reach the buyer. The buyer, then for their part, is prepared to pay for the goods if they arrive in good condition. The buyer can place the money or funds in escrow with an agent with instructions to disburse the money to the seller once the goods arrive in good condition. Through this way, both parties are secured and the transaction can proceed.

What does an escrow account cover?

Your escrow account covers regular property taxes and homeowners insurance. They also cover flood insurance if it’s needed in your location. However, it does not cover water or sewer bills or one time assessments by the federal government. It will also not cover homeowner association dues or supplemental tax bills.

Your escrow account covers regular property tax and homeowners insurance. Not to mention, it also covers flood insurance when required in your area. What it does not cover, however, are water bills, sewer bills, or one-time assessments made by your local government. It also does not cover for homeowner association dues or any supplemental tax bills.

Establishing an escrow account at closing

You have to keep in mind that your lender will collect enough funds to make an escrow account when you close on your loan. A part of your mortgage payment will go into your escrow account and your lender will use those fees to pay your taxes and homeowners insurance bills when they are already needed. This will happen every month. This will continue for over 12 months making it easier on your bank account. Also, it’s your lender who is making the payments so you don’t have to feel stressed out about remembering them every month.

When do you need an escrow account?

It actually depends on your kind of mortgage and your lender when it comes to needing an escrow account.

Government-backed loan options such as FHA and USDA loans need an escrow account. Lenders of other conventional loans can decide if an escrow account is needed.

Having an escrow account is still a good idea even though this is not necessary. You’ll be responsible for paying for your property taxes and insurance yourself if you don’t acquire an escrow account. You have to figure out yourself how to handle budgeting and paying them on time when you don’t have an escrow account.

Your lender manages the payments and also the budgeting for you when you have an escrow account. Your taxes and insurance payments can be well managed for over a year instead of paying the total amount all at the same time.

How do escrow accounts work?

Basically, when you acquire a mortgage loan from a bank or direct lender, you also obtain an escrow account that will help you pay for your property taxes and homeowners’ insurance premium at the right time. Although these are usually paid on a yearly basis, your lender will ask you to pay each cost on a monthly basis and gather the balance in your escrow account. This is guaranteed that your expenses can get paid on time every year.

In addition, mortgage lenders will ask the borrower to have escrow accounts in order to lessen the risk to fail on your monthly financial obligations as a homeowner. Unpaid taxes or insurance can lead to charges that will make it difficult for the mortgage lender to reclaim the original loan. This makes a strong incentive for lenders to have their borrowers on track with their escrow accounts that handle the non-mortgage expenses of owning a home.

Escrow accounts, however, also have some fallbacks for the borrower even though they are convenient to pay the needed taxes and insurance premiums on your behalf. Lenders will often ask you to keep a minimum balance in your escrow account to safeguard you against any unexpected cost increases. They usually require a minimum of two months’ expenses on your mortgage escrow account. The limit can be higher though on riskier mortgages. Your lenders will review your escrow account once a year in order to make sure that the calculated payments are on par with the costs.

More details on how escrow accounts work

An escrow account is usually made to collect your payments for your property taxes, homeowners insurance, and other items in equal amounts over a 12-month period to be paid on your behalf when those bills are due. You can still handle these bills yourself if your lender agrees.

However, the choice is entirely up to your lender or more likely, your investor that buys your loan. Your investors want to make sure that your bills can be paid so they always require an escrow account. If your property taxes are not paid, this will result in a lien against the house. Furthermore, if your insurance is not up to date and you suddenly have a fire that causes major loss, there will be no protection from the expenses of renovating your property. This serves as the underlying collateral for your loan.

For new buyers, your lenders’ fund mortgages. However, they usually sell their loans shortly after closing to investors on the secondary market. These investors could be a different bank, a pension fund, or a foreign investment group. However, the person who ends up with your loan usually hires a third-party servicing company to collect the payments and disperse the funds. The term “lender” would also refer to your investors and servicers.

How can your escrow account pay for homeowners insurance?

Having an escrow account is like having a separate bank account you handle with your mortgage lender. This certain account can help you set aside money every month for your bills that are intended for your property and usually come due as a combined sum such as your property taxes and homeowners insurance together with your other bills like private mortgage insurance.

You make a single monthly payment that includes both your loan and escrow payments when you have an escrow account. Basically, your escrow payment covers part of your property taxes, mortgage insurance, and homeowners insurance. You may also be able to earn interest on the balance in your escrow account.

Furthermore, your mortgage lender usually uses the fund in your account to pay those bills on your behalf when your taxes and homeowners insurance fall due.

Why escrow taxes and insurance fees?

Most people find it is easiest to pay for their taxes and insurance on a monthly basis so they use escrow accounts. In reality, it usually takes an extremely disciplined person to remember to set aside money every month on their own so there’s enough money to pay your bills when they are due every year. If you’re not careful with your money, you’ll easily use your money for other bills if it is just sitting in your desk drawer or even in the bank. Having an escrow account is like a kind of forced savings. This assures that your bills will be paid on time without penalty or late fees.

An escrow account is set up to collect payments for your property taxes, homeowners insurance, and also other items in equal amounts over a 12-month period to be paid on your behalf when your bills come due. When your lenders require escrow accounts, the law limits the amount borrowers must pay. In general, the lender will divide the cost of your anticipated property tax by 12 and collect that much each month and also your payment for principal and interest. This will also cover the cost of your homeowners’ insurance and other items for which your escrow might be required like your homeowners’ association dues or flood insurance. If taken all together, these expenses will equal your payment to escrow.

How is the amount of money placed in escrow decided?

In order to get an idea of how much your monthly escrow payment will be, just add up all these charges and divide by 12. For example, if your yearly tax bill is $2,000 and your insurance is $600 a year, then your escrow payment will be $216.67, or $2,600 divided by 12.

It’s also good to keep in mind that the law allows lenders to maintain a “cushion” of no more than one-sixth of the total amount paid out of an escrow account. This is two months’ worth of payments so that your escrow account always has a balance. Also, take note that your escrow payment could change each year if your taxes or insurance expenses increase or if the cushion amount needs adjusting.

All these things should happen automatically. You should still check your account from time to time since mistakes on your account can still happen. You’ll know something is wrong if you get a late notice from the county or your insurance company. However, fret not, the lender will pay for all the penalties for failing to pay on time.

The law usually requires that you should be given a complete breakdown within 45 days after making an escrow account showing the anticipated amounts to be paid over the coming year. You must also have a free yearly statement that documents activity in the account. The statement should have what bills were paid and when so as an explanation of how much you must pay in each of the next 12 months to keep your account standing current. 

When the loan is new, lenders usually low estimate the amount they collect for taxes and insurance since they can only estimate these expenses. It also makes your first payments more affordable. We suggest planning an increase in the escrow portion of your payment after the first 12 months.

How escrow analysis works

Kindly know that your mortgage service will calculate the amount you need to pay for your real estate tax homeowners insurance bills. This is provided during closing and is based on the taxing authority and insurance company and also on your previous taxes and insurance bills.

Your mortgage service will examine your account to ensure that you’re paying the correct amount to maintain the minimum required balance. They have to do this every year. The amount can be overestimated or underestimated since it’s based on an estimate. This is what you call an escrow shortage or overage.

In case there’s an overage, you’ll have a refund back into your account. Meanwhile, if there’s a shortage, you’ll have a number of options to pay the remainder. The first option is to pay for the full shortage upfront. The second option is to pay the shortage for a period of 12 months together with the regular payment. However, some service providers do not really allow this. This depends on them.

How escrow works when buying a home

You’ll usually include a personal check of 1% to 2% of the purchase price when you make an offer on a certain house. This is what you call “earnest money”. This shows the seller of the home that you’re a serious buyer of their property. In addition, the check won’t be deposited until the seller of the property accepts your offer.

You’ll have your money back in case your offer got rejected. Meanwhile, the money will go into an escrow account if the offer is accepted. It will be held until it’s time to close the deal. Then, the money will be used for your downpayment and closing costs.

In this kind of scenario, the escrow account acts a neutral wherein your money is stored until all paperwork is done and your home is officially called yours.

How much do escrow fees cost?

The escrow agent will, of course, be needed to be paid a fee just like any other service providers. Escrow services for home purchases usually cost 1% to 2% of the final price. This is usually from $2,000 to $4,000 which is added into your other closing expenses. These are also negotiable between the buyer and seller meaning that you can try asking the other party to even all of the escrow fees. This depends on local rules or current market conditions.

If you’re purchasing a property, you’ll need to deposit between 1% to 3% of the final sale price in a joint escrow account with your seller. This what you call “earnest money” proves that you’re serious about buying the sale and also requires the seller to remove the property from the market when the transaction is finalized. When the transaction is complete, the earnest money you placed in your escrow account will go towards your down payment on the property. Earnest money in escrow is not a fee. However, be aware that it’s possible to forfeit that money if you fail to come into a final agreement with the seller.

What if you have an escrow shortfall or surplus?

Your lender will offer some options to make up the difference if there’s a shortfall in your escrow in any given year. One example, you can pay the shortfall in full or via 12 equal payments over the following year so the deficit is made up by the next anniversary of your loan. In some cases, you may be offered a combination of the above. You could also pay some now and the rest for the next 12 months.

In case there’s a surplus in your account, the lender collected too much over the previous year. If there is a collection above a certain amount, the lender will send you a check. For smaller surpluses, the lender will apply it to next year’s escrow payments. If you’re given a choice, learn that what the lenders gave in one year is likely to be taken away next year in the form of a tax increase or higher insurance premiums.

When is escrow needed in a mortgage?

Escrow is important in both your initial home purchase and your ongoing monthly mortgage payments that follow. The escrow process assures both the buyer and seller. At the moment that both parties agree on a sale, a neutral third party; usually a bank, title company, and attorney will receive the signed purchase agreement. They act as the escrow agent. They exist to monitor and fulfill the conditions of the sale such as the buyer’s “earnest money” deposit for a certain percentage of the sale price.

Typical components of escrow in real estate

Buyer

  • earnest money towards the down payment
  • proof of mortgage loan approval

Seller

  • access to the property for inspections
  • required repairs or renovations
  • inspection of title

When a property is already “in escrow”, the buyer and the seller will not receive anything from the escrow company until all the conditions of the purchase agreement are finalized. One example is you might agree to purchase an older property on one condition that the building passes a safety inspection. Other conditions include repairs and property tax audits. Furthermore, the buyer’s earnest money guarantees that the buyer has serious intent and the ability to complete the purchase. This earnest money can be forfeited to the seller if the buyer backs out or fails to stay true to their contract.

One responsibility of escrow agents is to distribute money to parties other than the buyer and seller. These may be commissions to the real estate agent, prepaid mortgage interest to the lender, recording fees to the county office of records, and the escrow agent’s own fees. Without having an escrow account, you’ll be held responsible for sending on time and accurate payments to each and every party involved in the transaction in purchasing a property.

What are the pros of an escrow account?

First, having an escrow account helps you make sure that you have enough money every month to pay for yearly, lump-sum expenses for your insurance and taxes. Second, your mortgage lender usually takes care of paying for your mortgage insurance and property taxes. If you don’t have an escrow account, you’ll have to handle those payments yourself. However, it is still important to check your statements from your tax authorities and mortgage insurance company to ensure that your bills are paid correctly. Also, obtaining an escrow insurance account may give you peace of mind knowing that you have enough budget for some of your annual expenses for being a homeowner.

More benefits:

It’s automatic

One of the pros of having an escrow is it’s automatic. Having your mortgage lender holds your property tax and homeowners insurance payments in escrow guarantees that those bills will be paid on time and automatically. The good side of this is you will avoid penalties such as late fees or potential liens against your home.

You’re covered when there are shortfalls

It is natural that your homeowners’ insurance premiums and property tax assessments can fluctuate over time. For example, if your escrow account happens to fall short due to your property tax bill increasing, your service will usually cover the difference temporarily and will increase your monthly mortgage payment to make it up.

No surprises in having an escrow account

You’ll know what to expect most of the time since the exact amount needed for your escrow account is added to your monthly mortgage payment for you. If the escrow component of your monthly mortgage payment needs to increase, you’ll get a written notice from your lender or servicer. Furthermore, your lender or servicer is needed to send you a yearly escrow statement that shows the amounts you have paid together with any overages or shortages.

Potentially lower mortgage costs

You’ll be able to get a discount on your interest rate or closing costs just by having an escrow account. This depends on your mortgage lender.

What are the cons of an escrow account?

Things that could not work for you

It’s automatic

Having your escrow account automatic is also a disadvantage for some. This certain feature can be a con for savers who may be able to use the funds to much better use since your mortgage lender or servicer is allowed to collect the amount of your homeowners’ insurance and property tax payments, plus a cushion every month in your escrow account.

You might miss out on short-term investment opportunities

At the same time, the money that could end up as an overage in an escrow account could be used for short-term investments. Instead of allowing a bank or lender to reap the gains, earning interest on such investments may make more financial sense.

A potentially large upfront payment

Oftentimes, making an escrow account requires a homebuyer to deposit an amount equal to several months of property taxes and insurance premiums. These are called “prepaid” and can add to your mortgage closing expenses.

Can be tough to get rid of

It can be hard to remove this account later if you change your mind once you already have an escrow account with your lender or servicer.

Can be targeted by scammers

Escrow accounts contain large amounts of money and they can be attractive targets to scammers. Cyber thieves usually set up fake websites to phish for your personal information such as your name, bank account no, and even your credit card number. Some even go to lengths to even set up fake phone lines to build up trust with you.

The bottom line on escrow accounts

Opening an escrow account is an essential part of the process when purchasing a property. It may be required depending on the kind of loan you acquired. Having an escrow account can help you get peace of mind since it offers protection for you and is a convenient solution for paying for your taxes and insurance.

Depending on the requirements of your loan, maintaining a mortgage escrow account may or may not be required. Most mortgage lenders allow homeowners like you to make property tax payments directly to the county assessor and homeowners insurance payments to their insurance provider. However, to have this option, they usually require a loan-to-value ratio below 80% meaning you already made a down payment of at least 20% on your property.

In conclusion

Having an escrow account is a common financial tool mortgage lenders and servicers use. This helps ensure that your responsibilities as a homeowner are met without much hardship on your part. Your main responsibility is making your mortgage payment. If escrow is not really required, you may want to use alternative methods for your funds.

Ask us any questions

Now that you have read about escrow accounts, please don’t hesitate to ask us any questions if you have something in mind, especially when it comes to homeowners’ insurance in Denver, Colorado. You may contact us via our phone numbers and email. Please also don’t hesitate to check our other blog entries about homeowners insurance. Have a great day!