What Is Escrow? The Meaning and How It Works

Pros and Cons of Escrow Accounts

Escrow accounts do have some drawbacks, but generally, the benefits outweigh them. Make sure you understand the pros and cons of escrow accounts as you start the homebuying process.

Benefits of an Escrow Account

There are some big benefits to escrow accounts, both during the homebuying process and when you're covering your property taxes and insurance.

During the buying process, making a larger earnest money deposit can help you get your offer accepted since it gives the seller more peace of mind. Of course, buyers don't give this money directly to the seller because they might have to walk away from the home purchase for a legitimate reason.

With a neutral third party holding the funds, sellers can feel confident in withdrawing their home from being an active listing because they have the earnest money to ensure the buyer doesn't just walk away on a whim.

Paying into escrow for property taxes and insurance also benefits you in a few important ways, including the following:

• It ensures property taxes are paid on time. This helps reduce the risk of penalties, liens, or even foreclosure.
• It offers the convenience of adjusting annually. Your escrow payments adjust once a year to reflect changes in taxes and insurance, helping you maintain more predictable monthly expenses. You also get any extra escrow funds returned each year that is left after all payments are made.
• It allows you to avoid large lump-sum payments. This helps you spread out costs over time so you’re not scrambling to pay them all at once.

Some lenders and mortgage options require escrow, but others allow you to waive it. Even if you can waive it, think seriously about putting money into your escrow account anyway to smooth out your monthly expenses and make budgeting work better.

Drawbacks of an Escrow Account

There is no real disadvantage of an escrow account when you're buying or selling a home, other than buyers must tie up some money for a little while during the buying process. Since you're earnest money deposit typically goes toward your down payment or closing costs, that's not a big con.

As far as the escrow account you pay your property tax and insurance payments into, there are some disadvantages, including:

• Higher monthly payments. Some homeowners may prefer to pay taxes and insurance as a lump sum instead of increasing their monthly mortgage payment.
• Tying up your money. Funds in an escrow account aren’t easily accessible and can’t be used for other expenses.
• Potential escrow shortages. If taxes or insurance increase, you may need to cover the shortfall with a lump sum or higher monthly payments.
• You don't earn interest. Funds in an escrow account typically don’t generate returns like they would in a savings account.

These downsides are almost always outweighed by the benefits, but they’re still worth considering if you can opt in or out of escrow.

Escrow Account FAQs

Still want to know more? Here are answers to frequently asked questions about escrow accounts.

Is an Escrow Account Required?

You’ll always have to have escrow on certain kinds of loans, such as FHA loans, but your lender may offer the option to waive escrow on conventional loans. Lenders consider many factors when deciding whether to waive escrow, including the loan type and loan-to-value ratio. There may also be a fee to waive escrow.

Why Do Lenders Require Escrow?

Lenders follow mortgage guidelines that require an escrow account to make sure property taxes and homeowners insurance are paid on time. This protects the lender’s investment and protects you from tax liens. It also simplifies budgeting by spreading these large expenses into manageable monthly payments.

Can You Remove Escrow from Your Mortgage?

You may be eligible to remove escrow from your current mortgage depending on loan type, your lender's policies, and your consistent payment history. Ask your lender what is required to remove escrow from your mortgage. Again, there is often a fee for not using an escrow account.

Can You Opt Out of Escrow?

Some lenders may let you opt out or waive escrows on a new conventional loan if you meet certain requirements, like having at least 20% for a down payment. Your lender may also consider your payment history, allowing you to opt out if you show consistent on-time payments. Make sure to talk to your loan officer about specific requirements and fees for opting out of an escrow account.

What Is an Escrow Shortage?

An escrow shortage occurs if there’s not enough money in your escrow account to pay the property taxes or the insurance bill. If your property taxes or insurance are higher than the estimated amount for the year, you may have an escrow shortage. You'll have to correct this by making either a large lump-sum payment or increasing your mortgage payment to make up for the shortfall over time.

What Is an Escrow Refund?

An escrow refund occurs when you have a surplus of money in your escrow account. This can happen if your property taxes or homeowners insurance costs decline, or if you pay off or refinance your mortgage with money still in your escrow account. Your lender will send you the extra money back. Typically, this happens automatically, and you don't need to request it.

Will Your Escrow Payment Change over Time?

Your escrow will likely change as property taxes and mortgage insurance rates change. Typically, this happens once a year after your lender completes an escrow analysis to determine what adjustments to make. Your lender is generally required to notify you within 30 days of completing the analysis.

Final Thoughts: Why Escrow Matters When Buying a Home

Escrow accounts can be very helpful when buying a home by making sure your property taxes and insurance are paid on time. While not everyone wants or needs an escrow account, you should talk with your lender about whether it’s required or optional.

Freedom Mortgage offers flexible loan options with and without escrow accounts. Reach out to learn about what money-saving loan options are right for you and to take the first step to getting a mortgage to buy the home you've been dreaming of.