- Escrow is an arrangement of a third party holding money in an account.
- When you make an offer on a home, you’ll hold a “good faith deposit” toward your down payment in an escrow account until you close.
- You’ll likely also have an escrow account when you own the home, for the lender to cover insurance and tax payments.
- Not every type of mortgage requires an escrow account once you own a home, and you may be able to close it later if you’d rather pay for taxes and insurance without going through your lender.
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Escrow is the legal process of a third party holding money in an account until you meet certain requirements. These accounts are known as “escrow accounts,” and you don’t need to handle the money — the escrow agent will handle using the money appropriately.
Types of escrow accounts and how they work
There are two types of escrow accounts. You’ll use one in the homebuying process and the other after you’ve bought the home.
1. Escrow account for buying a home
When you make an offer on a home, you’ll place a “good faith deposit,” also known as an earnest money deposit.
A good faith deposit shows you’re serious about buying the home, and the seller takes it off the market. The escrow agent keeps the money in an escrow account until the purchase is finalized, then puts the money toward your down payment. (So if you have a savings account for your down payment, you can use it for your good faith deposit.)
What if you don’t end up buying the house? If you simply change your mind, the seller will keep your good faith deposit. If you back out for specific reasons, like the appraisal or inspection shows major problems with the home, you’ll probably be able to keep the money. The escrow agent will help you deal with any issues.
A good faith deposit is usually 1% to 3% of the home purchase price, or $1,000 to $3,000 for every $100,000. You’ll also pay the escrow agent a fee of 1% to 2% of the purchase price, which is included in your closing costs.
When someone says they are “in escrow,” it typically means they have placed their good faith deposit and are waiting to close on the home.
2. Escrow account for taxes and insurance
When you buy a home, your monthly mortgage payments go toward your principal and interest. But you’ll also have other costs each month, including property taxes, homeowners insurance, and mortgage insurance.
You may pay for these expenses separately from your mortgage, or you can roll it all into one payment so you don’t have to worry about remembering multiple payments every month.
If you roll it all into one payment, your lender will open a separate escrow account to keep money for your taxes and insurance costs. This way, the lender is in charge of paying your tax and insurance companies on your behalf, and it withdraws the money from your escrow account to do so. The lender gets that money back when you make one all-encompassing mortgage payment to the company each month.
The lender may also require you to keep extra money in the escrow account to cover any potential increases. It might ask you to put two months of estimated expenses into the escrow account at closing as a cushion. Your tax and insurance expenses can change over time. If the lender realizes it’s charged you too much, you’ll receive a refund. If you haven’t paid enough, you’ll need to cover what’s left.
Keep in mind that your escrow account won’t hold funds for expenses like utility bills or homeowner’s association dues. You’ll still have to pay for these services separately.
Most types of mortgages require you to have an escrow account for your insurance and tax payments, but not all. Here are the rules for each type of mortgage:
However, just because you need an escrow account at the beginning of homeownership doesn’t necessarily mean you’ll need one forever.
Let’s break this down by both types of escrow accounts.
For the escrow account when buying a home (the one that holds your good faith deposit), you’ll probably keep the deposit in the escrow account for about 30 days. That’s roughly the length of time between when you make an offer and when you close on a house.
For the escrow account that holds money for your monthly payments, it will depend on your situation. For a conventional mortgage, you may be able to close your escrow account once you’ve attained enough equity in your home to cancel private mortgage insurance. You can request to cancel PMI once you have 20% equity, and lenders are legally required to cancel it once you hit 22% equity.
You can’t close an escrow account on an FHA or USDA mortgage. For a VA mortgage, it may depend on your lender.
Some lenders also require you to meet certain criteria before you can close an escrow account. For example, maybe you’ll need to have the mortgage for at least five years and make all your payments on time.
You may decide you want to close your escrow account so that you don’t have to maintain an escrow cushion. But you also might want to keep it open so that you don’t have to worry about making several separate payments each month.
Laura Grace Tarpley is the associate editor of banking and mortgages at Personal Finance Insider, covering mortgages, refinancing, bank accounts, and bank reviews.
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