Understanding an Escrow Account (Explained in Plain English)

Escrow accounts are used to ensure payments of home owner’s insurance and property taxes when a home is financed through a mortgage company or financial institution (bank). In the case of a mortgaged home, the taxes and home owner’s insurance is vital in securing the property against damage or lien due to taxes or civil judgment. Since the buyer will not officially own the home until the mortgage has been paid in full, the escrow account is established to guarantee the insurance premium payments and property tax payments in the name of the lender.

Establishing the Account

In most cases, the burden to establish the escrow account is with the lender or mortgage company. In other more rare cases, the escrow account can be established by the buyer to secure the payments due to the insurance company and taxing municipality. Not all sales require the escrow account. A mortgage granted with less than a 20 percent down payment is usually always required to be secured by the establishment of an escrow account to mitigate the risk of default assumed by the lender. 

Determining the Escrow Account Payment Terms

The common format of terms for a purchaser’s payment includes the principal payment, tax payment and insurance premium combined. The tax payments are derived from an estimation of the yearly property taxes divided by the number of payments to be made in one year. The home owner’s insurance payments are also divided into equal payments over one year. The total of the estimated taxes and insurance premiums are withheld from the buyer’s payments each month and deposited into the escrow account.

Making the Tax and Insurance Payments

The establishment of the escrow account is for the sole purpose of ensuring the taxes and insurance premiums will be paid, in full and on time. The responsibility of making the payments is held by the mortgage company or lender. The lender will have authority to deduct the accumulated payments from the escrow account and tender the payments to the separate entities for tax and insurance payment. The buyer is commonly not burdened with the responsibility to see that the payments are made.

Managing Risk with an Escrow Account

Many factors are weighed during the buying process. While not every buyer is required to have an escrow account established in order to mortgage their home, lenders see the establishment of an escrow account as a way to mitigate the risk of default. As such, buyers are often given credit for agreeing to the escrow account format and receive more favorable mortgage terms. In some cases, agreeing to the escrow account will make the difference between receiving the mortgage or being denied the funds to purchase the home altogether.