The Mortgage Escrow Process Explained

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Escrow. The word itself causes confusion among first-time home buyers. What do escrow companies do during a real estate transaction? How does the mortgage escrow process work? How long do they hold on to the money? These are just a few of the questions we receive from our readers. This article provides the answers.

In a nutshell: The word "escrow" can mean different things. The escrow period is the time between the offer and the closing day. It also refers to something that is placed into the custody of a neutral third party. And that's exactly what a mortgage escrow company does. They hold and distribute funds related to the sale of a home. They can also manage payments for property taxes and insurance, on the homeowner's behalf.

How the Process Works

An escrow account is basically a safe place to put money when buying a home. The funds are not accessible to the buyer or seller until all of the contract's terms have been met. The person who manages and protects the account is called an escrow agent. It is their job to ensure all funds are properly distributed on closing day. They do this in accordance with the contract / agreement that was signed by the buyer and seller.

The mortgage escrow company will only release the funds when the terms outlined in the purchase agreement have been met. These terms are created when you first make an offer to buy a home, and they are finalized when the seller accepts your offer and conditions.

The purchase agreement will normally spell out the following:

  • The amount of earnest money deposit the buyer is paying
  • The purchase price agreed upon by both the buyer and seller
  • The real estate agents involved, and how much their commissions are
  • Any contingencies or conditions that must be met for the sale to go through
  • The desired time and date for the real estate closing to take place

There will be additional information as well, but these are the items that relate to the escrow process. The mortgage escrow company / agent will make sure that all of these contract stipulations are met, before releasing funds on closing day. So the contract between the buyer and seller also serves as a set of instructions for the agent.

There are actually two sides to the mortgage escrow process.

  • On one hand, the escrow account protects the buyer and seller by ensuring the proper collection and distribution of funds at closing. We talked about this above.
  • An escrow account can also be used to protect the lender, by ensuring the borrowers pay their homeowners insurance and property taxes on time. We will discuss this topic next.

Escrow Account for Taxes and Insurance

Your mortgage lender has a large investment in your home. Even if you make a down payment of 20 percent, the lender contributes the remaining 80 percent. So they have more at stake than you do. As a result, they want to make sure the home is properly insured and current on all taxes.

They use the escrow account to protect their investment in the home. Specifically, the mortgage company is concerned about two things:

  • If the homeowner stopped making insurance payments, the lender would be exposed to more risk. What if the house was lost to a fire or other disaster? The lender would have no collateral to support the loan.
  • They also want to make sure the homeowner stays current on property taxes. If the homeowner neglects to pay taxes, a tax lien could be placed on the house. This could prevent the resale of the home.

Your mortgage lender may require you to set up an escrow account to cover the costs associated with your property taxes and insurance. You would deposit an initial sum of money into this account, and then pay into it each month to cover those two expenses.

But it doesn't always work this way. In some cases, the lender will leave it up to the homeowner to make the payments for property taxes and homeowners insurance. The rules vary by state, and also depend on the lender you use. In some states, home buyers are required to set up an escrow account for taxes and insurance. In other states, these accounts are optional.

If you do use an escrow account for making these payments, your taxes and insurance will essentially be "rolled into" your monthly mortgage payment. You make a single payment each month, and it goes toward three things: (1) your mortgage principal plus interest, (2) your property taxes, and (3) your homeowners insurance premium. 

Even if the state doesn't require an escrow account, some lenders will require it. Others will simply present it as an option. The taxes and insurance must be paid either way. The difference is in how they are paid, and who is actually sending the payment (the homeowner or the mortgage company). It varies from one mortgage company to the next. In the wake of the housing crisis, however, I'd venture a guess that more lenders today are requiring these accounts for their own protection.

Most home buyers prefer to have their taxes and insurance spread out over 12 monthly payments. It greatly reduces the amount you have to pay at any one time. Without the escrow account strategy, you would have to pay them as a lump sum each year -- or as two larger payments instead of 12 smaller ones.

Homeowners also have the comfort of knowing that someone else is keeping track of their payments and due dates. You don't have to worry about when your next property tax payment is due, or your next insurance premium. The mortgage company manages this and makes all payments on time for you.

This article explains how the mortgage escrow process works when buying a home. If you would like to learn more about the process of buying a house, you can use the search tool at the top of this page. You'll find hundreds of related articles in our research library.