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What is an escrow account?

Unless you’ve purchased or sold a home, you probably haven’t learned much about mortgage escrow. So you might ask yourself, what is an escrow account in a mortgage?

When borrowing from a lender to finance a home purchase, it’s certainly a priority to know how much you’ll pay each month to cover the mortgage loan principal and interest. But in most cases, you’ll also be required to make monthly payments into what is known as an escrow account. That money goes toward paying property taxes and homeowner’s insurance premiums.

With an escrow account, a portion of a borrower’s monthly mortgage payment gets deposited into a third-party holding account arranged by the lender. The lender uses those funds held in escrow to pay property tax bills and homeowner’s insurance premiums on behalf of the homeowner.

What is included in an escrow account for mortgage?

An escrow account’s payments get estimated during the mortgage application process and finalized at closing. Lenders often use the acronym PITI — principal, interest, taxes and insurance — when estimating the total monthly mortgage payment and determining the affordability for an individual mortgage.

Lenders calculate escrow account payments on a 1/12 basis, meaning the total annual price you pay for homeowner’s insurance and property taxes gets divided into 12 monthly payments. Here’s an example:

If your insurance premiums and property taxes each cost $1,200 annually, your lender will collect $200 per month in escrow for the 12 months in a year — with $100 of your monthly escrow balance going toward insurance and $100 toward taxes.

As your lender receives the bill from your chosen insurance carrier and from your local government’s property tax office, they will automatically pay the bills using the escrow account funds, so you avoid penalties such as late fees or liens against your property for non-payment. Escrow accounts also serve to protect the lender by making it less likely you’ll fall behind on these essential payments.

While lenders will sometimes waive escrow for borrowers who pay 20% or more in their down payment, most lenders mandate that borrowers establish an escrow account to cover property taxes and homeowner’s insurance costs. Most government-backed mortgages, including Federal Housing Administration (FHA) and U.S. Department of Agriculture (USDA) loans, require an escrow account no matter the size of the down payment.

Determining what your escrow balance is

If you’ve ever had a home mortgage before, you’ve probably noticed your mortgage statement lists an escrow balance. What is escrow balance, and how does it differ from the loan’s principal balance? The principal balance only accounts for the amount owed on the property’s loan. It does not include interest or other fees and charges.

Your local government determines how much you’ll owe for your annual or semi-annual property tax payment. It’s calculated using the assessed value of your property, combined with tax rates for local schools and governmental agencies.

As a homebuyer, you can seek multiple quotes for homeowner’s insurance coverage and pick the provider with best coverage for your circumstances. However, your lender may require certain coverage to be included in your policy, such as flood insurance if the home’s located in a flood zone. These terms are established during the mortgage closing process.

If your homeowner’s insurance premium costs increase over time, you can look for a new insurance provider with better rates. Just be sure to communicate any insurance changes with your lender, so they can ensure all bills are paid in full and your escrow account balance is adjusted accordingly.

A lender may add to your monthly escrow payment the equivalent of two months of escrow payments each year to ensure that what is in your escrow account covers any price increases on your insurance premium or property taxes. At the end of the year, the lender must provide a statement of what the escrow balance totals and refund any outstanding escrow balance beyond $50.

If you’re looking to buy a home and want to learn more about what an escrow balance is, we can help. Call 1.800.205.3464 or find a banking center near you to speak with a home mortgage expert.