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When you have an escrow account, part of each mortgage payment will go into the account. Your mortgage lender or servicer will then use the money to pay your property taxes and insurance premiums.
Having an escrow account can help homeowners more easily budget for these major expenses and reassure mortgage lenders that the bills will be paid on time. However, you'll want to understand what affects your escrow payment and why it could lead to changes in your mortgage payments.
What Is an Escrow Account?
An escrow account is a deposit account that your mortgage servicer manages. You contribute to the account from your monthly mortgage payment, and the loan servicer spends the money on specific bills on your behalf.
Your mortgage servicer might require you to have an escrow account, also called an impound account, if you have a government-backed loan or if you have a conventional mortgage with less than 20% equity. It may also offer you the option of using an escrow account even if it's not a requirement.
Four Parts of a Mortgage Payment
If you have an escrow account, your mortgage payment will usually be made up of four parts:
- Principal
- Interest
- Property taxes
- Insurance
While principal, interest, property taxes and insurance, or PITI, is the norm, not every lender requires you to use an escrow account to pay your property taxes. You may choose to pay them separately from your mortgage payment. The amount you pay for your principal and interest payments goes to the mortgage servicer, and the remainder goes into your escrow account.
The mortgage servicer can use the money to pay your property tax bills, homeowners insurance, mortgage insurance and flood insurance. But your escrow account usually won't cover certain home-related expenses, such as utility payments or HOA dues.
Because the mortgage servicer is paying the bills on your behalf, they could also be responsible for late fees if they miss a due date. But you may still want to make sure your insurance payments are made on time to avoid lapses in coverage.
How Are Escrow Payments Calculated?
Your monthly escrow payment is calculated by dividing the estimated annual total for your property taxes and insurance premiums by 12. For example, if your property taxes and insurance premiums are estimated to be $3,600 this year, you'll have to pay $300 a month.
Additionally, you may need to maintain a cushion in your escrow account, which may be capped at one-sixth of the annual cost—or two months' worth of payments. When you buy a home, you may need to make a prorated payment plus contribute enough to cover the cushion. These expenses are usually included in your closing costs.
How Do Annual Escrow Reviews Work?
Your mortgage servicer will conduct annual reviews to make sure you're not overpaying or underpaying. It will send you an annual escrow review statement that shows you what happened over the past year and estimates for the coming year.
Your monthly escrow payments might change based on the findings, and you might have to make an additional payment or get a refund if there's an escrow shortage or surplus. Here's how they work:
- You have an escrow shortage: An unexpected rise in property taxes, your home's value or insurance premiums could mean you weren't contributing enough each month to cover your bills for the previous year. You might have the option of making a partial or full payment to cover the shortage, or spreading out the amount owed over the next 12 months. Either way, your escrow payments might increase to cover these higher costs going forward.
- You have an escrow surplus: Your property tax rates might decrease, you might get a revaluation and reduce your tax bill or you could try to change your homeowners insurance policy to save money. If this happens, you might have a surplus in your escrow account and your mortgage servicer may need to send you an escrow refund check.
Escrow shortages are fairly common, although you likely won't have a big shortage unless your homeowners insurance or property taxes quickly increases. Surpluses might not be as common, and if the surplus is for less than $50, your mortgage servicer might put it toward next year's payments rather than issue you a refund.
What Happens to Your Escrow Account After Paying Off Your Mortgage?
Once you pay off your mortgage, your mortgage servicer should close your escrow account and send you the money within a couple weeks.
You'll now be responsible for making your property tax and insurance payments on your own. Check with your insurance provider and local tax offices to make sure you know when these bills will be due and approximately how much you'll owe.
If you pay off your mortgage by refinancing the loan with the same lender, you might be able to keep the same escrow account. But if you refinance with a different lender that requires an escrow account, you might need to fund your escrow account when you close on the loan and wait for your refund.
The Bottom Line
Most homeowners who have a mortgage also use an escrow account. Understanding how the account works can be important, especially because it can lead to changing mortgage payments even if you have a fixed-rate mortgage. Planning ahead and looking for ways to lower your expenses, such as shopping for homeowners insurance, could help you budget.