What Are Escrow Costs and What Do They Include?

Escrow refers to a financial arrangement where a third party holds and regulates payment of funds and documents for two other parties involved in a given transaction. In real estate transactions, escrow accounts are a prevalent method for managing certain recurring costs associated with property ownership. This article clarifies what these specific costs entail and how they are managed through an escrow account.

The Role of Escrow Accounts

An escrow account, specifically for mortgage lending, functions as a dedicated holding account managed by the mortgage lender. Its purpose is to collect and disburse funds for recurring property-related expenses on behalf of the homeowner.

Lenders typically require escrow accounts to protect their investment. By ensuring essential obligations like property taxes and insurance premiums are paid on time, the lender safeguards their collateral. This practice reduces the risk of tax liens or uninsured damage that could devalue the property. The key parties involved include the homeowner, the mortgage lender, local taxing authorities, and insurance companies.

Typical Escrowed Expenses

Escrow accounts commonly include several specific types of expenses, each serving a distinct purpose in maintaining property ownership and protecting the lender’s interest. These expenses are grouped into the homeowner’s monthly mortgage payment, simplifying the payment process.

Property Taxes

Property taxes are levies imposed by local government authorities based on the assessed value of real estate. These taxes fund local services such as schools, public safety, and infrastructure. Lenders collect property taxes through escrow to ensure these significant annual or semi-annual payments are made, preventing potential tax liens that could take precedence over the mortgage. The amount of property tax is determined by the local tax assessor’s valuation and the prevailing tax rate.

Homeowner’s Insurance Premiums

Homeowner’s insurance provides financial protection against various perils, including damage to the home’s structure, personal belongings, and liability for injuries occurring on the property. Mortgage lenders typically require borrowers to maintain adequate homeowner’s insurance coverage throughout the loan term. This requirement protects the lender’s financial interest in the event of damage or destruction. Premiums are set by insurance providers based on factors such as the property’s value, location, construction type, and the specific coverage selected.

Mortgage Insurance (PMI/MIP)

Mortgage insurance protects the lender against losses if a borrower defaults on their loan. Private Mortgage Insurance (PMI) is required for conventional loans when the down payment is less than 20% of the home’s purchase price. For loans insured by the Federal Housing Administration (FHA), borrowers pay a Mortgage Insurance Premium (MIP), which includes both an upfront and an annual component. These insurance types are included in escrow payments to ensure continuous coverage, benefiting the lender by mitigating their risk. The cost of mortgage insurance varies based on factors like loan amount, loan-to-value ratio, and credit score.

Initial Escrow Deposit/Prepaids

At the mortgage closing, borrowers typically provide an initial escrow deposit, sometimes called prepaids. This lump sum payment establishes the initial balance in the escrow account. The deposit ensures sufficient funds are available to cover future tax and insurance payments when they become due shortly after closing. This initial funding usually covers a few months of upcoming property tax and insurance obligations, providing a buffer before regular monthly contributions accumulate. The Real Estate Settlement Procedures Act (RESPA) limits the amount a lender can require for this initial deposit to a maximum of two months of estimated payments.

How Escrow Accounts are Managed

After an escrow account is established, its management involves calculating monthly payments and regular reviews. Lenders estimate the annual costs for property taxes, homeowner’s insurance, and any applicable mortgage insurance. They then divide this total annual amount by twelve to determine the monthly escrow portion of the mortgage payment. Federal regulations, such as RESPA, permit lenders to collect a cushion, typically equal to two months of the total annual disbursements, to cover unexpected increases in costs.

Lenders conduct an annual escrow analysis to compare actual expenses paid from the account with funds collected from the homeowner. This yearly review, often called an escrow re-evaluation, determines if monthly payments need adjustment. The lender provides an annual escrow statement detailing the account’s activity and projecting future disbursements.

If the analysis reveals a surplus, the lender typically refunds the excess amount to the homeowner, provided it exceeds $50. Conversely, if a shortage occurs, the homeowner must cover the deficit. This can be done through a lump sum payment or by increasing future monthly escrow payments over a period, often 12 months, to replenish the account.

Changes in property taxes or insurance premiums directly affect the required monthly escrow payment. For instance, if property values increase, leading to higher taxes, or if insurance premiums rise due to claims or market changes, the annual analysis will trigger an adjustment. While the lender manages the account and makes disbursements to the taxing authorities and insurance companies, the homeowner remains responsible for funding the account through their regular monthly mortgage payment.