What is an escrow account on a mortgage?

An escrow account is a holding account your mortgage servicer uses to pay your property taxes and homeowners insurance. You pay one twelfth of those yearly bills with each mortgage payment, so your payment changes when the bills do.

What escrow covers

Escrow usually pays property taxes and homeowners insurance. If you have PMI, the premium is often collected with the same payment. Condo or homeowners association dues are usually paid separately, not through escrow.

Many lenders require it

Many lenders require escrow so they know the taxes and insurance get paid. Some loans must have it, such as higher-priced mortgages, which usually need escrow for at least the first 5 years.

The servicer has limits

For most mortgages, each month the servicer can collect up to 1/12 of the yearly bills it expects to pay, plus a cushion of no more than 2 months of payments.

Surpluses come back to you

If the yearly review finds a surplus of $50 or more and you are current, the servicer must refund it within 30 days. A smaller surplus can be refunded or credited to next year.

How an escrow account works

When you close on your home, the lender estimates your yearly property tax and insurance bills. You pay an initial deposit into escrow as part of your cash to close. After that, each mortgage payment has two parts: principal and interest for the loan, and an escrow amount for taxes and insurance.

Your servicer holds that money and pays the tax office and the insurance company when the bills arrive. You don't write those checks yourself. Your monthly statement shows how much of each payment went into escrow.

Why your escrow payment changes

Property taxes often rise when your home's assessed value goes up or your local tax rate changes. Insurance premiums change at renewal. Because escrow is based on those bills, your total payment can change even on a fixed-rate loan.

Once a year, the servicer runs an escrow analysis. It compares what it collected with what it paid, projects the next 12 months and sets a new monthly amount. You get a statement showing the math.

What a shortage means

A shortage means the account balance is lower than it should be for the year ahead, usually because a bill came in higher than expected. It isn't a penalty, and the money still goes to your own taxes and insurance.

For most loans, federal rules set what the servicer can do. If the shortage is at least one month's escrow payment, the servicer can let it stand or spread it over at least 12 monthly payments. If it is smaller, the servicer can also ask you to repay it within 30 days. Many servicers let you choose between paying it in one lump and spreading it out.

What a surplus means

A surplus means the servicer collected more than it needed. If you are current on your payments and the surplus is $50 or more, it must send you a refund within 30 days of the analysis. If it is under $50, it can refund it or apply it to next year's payments.

A surplus often shows up after your taxes or insurance went down, or after you switched to a cheaper policy. Your monthly escrow amount should drop at the same time.

Paying taxes and insurance without escrow

Some loans let you skip escrow. Then you pay the tax office and the insurer yourself, often in large lump sums once or twice a year. Ask the lender whether waiving escrow changes your rate or fees.

If you go this route, set up a savings account just for these bills and move 1/12 of the yearly total into it each month. Missing them is costly. Unpaid taxes can bring penalties or a tax lien, and if insurance lapses, your lender can buy force-placed insurance for you, which usually costs more, and bill you for it.