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How does escrow work with a mortgage?

If you've been planning to buy a house for a while, you've probably budgeted for your monthly mortgage payments. But what about additional costs like property taxes and insurance?

To cover these costs, most homebuyers deposit funds into a mortgage escrow account. These payments may be included as part of your monthly mortgage payment. Get a closer look at how escrow works with a mortgage and learn when you would need it.

What is an escrow account?

An escrow account allows a lender to collect and hold funds until they're needed. When you need to pay property insurance and taxes, your lender usually handles the payment from the account.

When you have a tax and insurance escrow account, the lender holds the funds that will be used to pay the required taxes and insurance for your home and is responsible for making the payments when they are due.

How does an escrow account work for taxes and insurance?

After you close on your house, you may need to set up an escrow account. Your mortgage lender or servicer usually sets up an escrow account to hold funds until it's time to pay expenses like private mortgage insurance, property taxes and property insurance.

What happens when you place tax and insurance money in escrow?

When you take out a loan to buy a house, your monthly mortgage payment may include more than just principal and interest. It can also include enough to cover a portion of the property tax as well as the homeowners, mortgage or flood insurance for your house. Many mortgage servicers collect money for tax and insurance and submit the payments to your insurance provider and property tax office on your behalf. Your money stays in your account until your tax and insurance payments are due. Most mortgage servicers require you to keep a certain minimum balance, such as two months of escrow payments, at all times.

In most cases, your mortgage servicer bases your escrow payments on the previous year's tax and insurance payments. If the amount you owe for taxes and insurance goes up or down over the course of the year, your mortgage payment may change.

Mortgage servicers provide an annual escrow analysis (pdf). This analysis provides an overview of your account, including account history and projected activity for the next year. It also highlights your current and new mortgage payments and confirms whether you have a surplus or a shortage. If you have a surplus, your mortgage servicer may include a refund check. If you have a shortage, your mortgage servicer will give you options to make the escrow deposit such as paying the shortage in full or distributing it over the next year's payments.

Do you have to keep tax and insurance money in an escrow account?

A monthly escrow account may be optional for some homebuyers, but many mortgage servicers require them. For example, if you take out a loan backed by the Federal Housing Administration (FHA), you're required to have an escrow account for taxes and insurance. If you take out a loan backed by the U.S. Department of Veterans Affairs (VA), you may not be required to keep money in escrow. Lenders may also waive the requirement depending on the amount of your down payment or any discount points or charge a higher interest rate.

Benefits of depositing tax and insurance money into an escrow account

If your mortgage servicer requires an escrow account, you don't have to worry about making property tax or insurance payments on your own. Instead, you can rely on your mortgage servicer to handle these.

In addition, you don't have to budget for tax and insurance payments since they're already included in your monthly mortgage payment. You'll pay a little every month, so you won't have to make a big tax or insurance payment once or twice a year.

Most mortgage servicers require at least two months of tax and insurance payments in escrow, so you'll automatically have some funds set aside.

Drawbacks of placing tax and insurance money in an escrow account

If you include the amount in your monthly mortgage payment, it will increase your payment and you can't use those funds to cover other expenses.

In addition, your escrow payments might not reflect the reality of your tax and insurance payments. Since most mortgage servicers base escrow payments on the previous year's insurance and tax statements, the amount you pay each month may be insufficient. That means you could end up having to cover a shortage.

Speaking to a Home Lending Advisor can help you understand the pros and cons of an escrow account.

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