Escrow Accounts, Explained

What is an escrow account?

In the context of your mortgage, an escrow account is designated primarily for payment of your property taxes and homeowners insurance plus any other required insurance. You pay into the account, which is managed by your mortgage lender, as you make your mortgage payment.

It’s an easy way to help you budget for property tax and insurance bills. You don’t have to save for them separately or even make the payments yourself—you only have to worry about making your total monthly mortgage payment, which lumps these expenses in a consistent amount.

It can be a little confusing that the word “escrow” also shows up in the “title & escrow” services provided during your closing. This account is unrelated to those services.

How it works

1 – When you close on your home, you pay a starting balance for the escrow account. The amount is determined based on when your next property tax and insurance bills are due. This starting balance is often referred to as “reserves.”

2 – As part of your monthly mortgage payment (which typically starts about 30-60 days after your closing date) you will pay one twelfth of your total insurance and tax bills (so that the entire year gets covered evenly). This part of your monthly payment (also known as your “escrow payment”) gets deposited into the escrow account.

3 – When your property tax and insurance bills are due, the lender will pay them on your behalf out of this escrow account. There is always a cushion kept in this account (about 2 months’ worth) just in case your property tax and homeowners insurance bills rise in following years.

4 – According to the Real Estate Settlement Procedures Act of 1974 (RESPA), your lender is required to re-analyze your escrow account once a year to determine if they have been collecting the right amount. If ever your actual bills are lower than planned, you can expect a refund from your lender. If your actual bills are ever higher than anticipated, your lender will adjust your monthly escrow payment to help cover the shortage or allow you to pay the difference in a lump sum.

Reserves & your initial payment

Your initial payment into your escrow account, which is due at closing, is affected by the state where you’re buying a home because the payment will contribute to property tax—and property tax schedules vary state by state. Generally, the initial payment is determined by when your closing date falls relative to when your next property tax payment is due.

We’ll use the example of Washington state, where Flyhomes is headquartered. The graphic below shows how many months of reserves are needed at any given time in Washington state. Due to the timing of bill payments, different amounts of reserves are required during each month.

Reserve requirements:

In Washington, property taxes are due in April and October. So, in those months you need 8 months of reserves—6 to pay the taxes and 2 as a cushion.

No matter what state you live in, homeowners insurance is due annually in the month you closed on your home. So, in that month (February in the graphic) you’ll need 14 months of reserves—12 to pay for insurance and 2 as a cushion.

WA state escrow account reserve requirements

Of course, when your escrow account is first set up, no reserves exist. Your starting payment will get you where you need to be based on the month when your first mortgage payment is due.

Example

The median home price in Seattle as we’re writing this is about $725,000. Using that as the assessed property value, annual property taxes on this home will be approximately $7,250. Homeowners insurance rates will vary depending on the insurance company, but let’s assume $700 annually.

In this example, closing in February with your first mortgage payment due in April, the account would require $4,229 (7 months’ worth) of property taxes as an initial payment, while closing in May with your first mortgage payment due in July would require $2,417 (4 months’ worth). For homeowners insurance, your escrow account is going to require 3 months of reserves, or $175, no matter what month you close.

While your initial payment is determined by the month in which you close, your monthly payments after the account is set up will not vary based on the month. The monthly payment amount will be one twelfth of your annual total property tax and insurance payment.

Common questions

Is an escrow account mandatory?

For most loan programs, it isn’t mandatory to have an escrow account. You can choose to budget for, track, and pay your tax and insurance bills yourself. It’s simpler to have the account, however. Any credits you receive as a part of your home purchase (from the lender, real estate agent, or seller) can be used to cover the starting balance. Plus, there’s no added cost for maintaining the escrow account.

Can I cancel my escrow account?

If you set up an escrow account and want to cancel it, you’ll need to show a 12-month on-time record of mortgage payments. You’ll also need to submit a written request to your lender. At that time, the remaining balance in the escrow account will be refunded back to you in full and you’ll be responsible for paying your insurance and tax bills moving forward.

What happens to the account when my mortgage is paid off?

When your mortgage is paid off, the remaining balance held in the escrow account will be refunded to you.


Check out more mortgage articles from Flyhomes Mortgage to learn why you don’t need to put down 20% to buy a home, credit score myths, what Private Mortgage Insurance (PMI) is, and more.


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