An escrow account is a special account that mortgage companies set up in conjunction with your mortgage account, and it is used to pay your taxes, insurance and mortgage insurance. Escrow accounts are sometimes referred to as escrows or an impound account.
When you close on a home and take out a mortgage loan, most loan programs and lenders require an escrow account to be set up. At closing, monies for property taxes, insurance and mortgage insurance are deposited into your escrow account. In most areas of the country, property taxes are paid annually or twice per year. Homeowner’s insurance is paid annually on the anniversary date of the closing of your house. Mortgage insurance is paid monthly from your escrow account to the mortgage company.
The mortgage company will calculate your taxes and insurance based on a monthly amount. These monthly amounts will be added to the base (principal & interest - P&I) mortgage payment giving you a total mortgage payment known as your PITI payment – principal, interest, taxes & insurance.
When you close on a home, the lender will require that the homeowner’s insurance is paid in full, in advance for one year, and if property taxes are due within 60 days of the closing date, they will be paid in advance too for whatever amount is due, 6 or 12 months.
When the escrow account is initially set up, the mortgage lender will require that a few months each of taxes and insurance money be deposited into the escrow account. The amount varies depending on due dates. Mortgage companies need to make sure that enough money is collected up-front to cover the bills when they come due, and federal loan servicing rules and regulations allow mortgage servicers to have a cushion built into the account in case of increase in the amount due over the year. So, as part of your closing costs, you will be required to pay into your escrow account an amount of taxes and insurance that allow for enough money plus the cushion to be in your account when the next bills become due.
Annually, your mortgage servicer is required to do an accounting of this escrow account. If the account is found to be short, you will be required to make up the shortage, or if there is a surplus, you will be refunded the surplus. If there is a shortage, most mortgage servicers will take a one-time payment or allow you to spread the shortage over the next 12 payments. Please note that if you are short, you not only need to make up the shortage, but your monthly PITI payment will increase to cover the increase in property taxes or insurance premiums.
FHA, VA, USDA loans and conventional loans with less than a 20% payment require an escrow account. Many other loan programs allow for the homebuyer to request a waiver to not have an escrow account. For most homebuyers and first-time homebuyers, an escrow account is a great idea.