How Does Escrow Work?
Reading time • 4 minutes
By Matic
Whether you’re in the homebuying process or already own your home, you’ve probably heard your mortgage lender talk about money that’s “in escrow.” They’re referring to an escrow account, which is a holding place for funds that are allocated for non-mortgage expenses, including homeowners insurance. According to a survey by property tax services company LERETA, roughly 80% of homeowners have an escrow account. But how does escrow actually work — and what happens if you change insurance companies?
What is an escrow account?
Escrow accounts are opened and managed by mortgage servicers and lenders. They’re used to hold funds that will eventually go toward expenses that are separate from your home loan. That often includes:
- Homeowners insurance
- Property taxes
- Mortgage insurance
- Flood insurance
Who needs an escrow account?
Escrow accounts are usually opened during the homebuying process. Whether you need one will depend on your lender and the type of home loan you’re seeking. Escrow accounts are required for government-backed mortgages like FHA loans and USDA loans. Conventional loans, which aren’t insured by the U.S. government, may be more lenient. They typically aren’t required for homebuyers who make a down payment of at least 20%, though you might be charged an escrow waiver fee.
Every lender is different, so the eligibility requirements to remove an escrow account can vary from one lender to the next. They’ll likely require you to have:
- A certain amount of home equity
- A strong track record of on-time mortgage payments
- No insurance or tax payments due within the next 30 days
How does an escrow account work?
You’ll make your regular monthly mortgage payments, but a portion of each payment will be funnelled into an escrow account to cover future property tax payments and insurance payments. The account will grow in value month after month, and when those payments come due, your mortgage lender will pay them on your behalf. That means you won’t have to worry about paying those bills separately.
Just be aware that many mortgage lenders will require you to prepay a portion of your annual property taxes and homeowners insurance premiums at closing. That can increase the upfront cost of buying a home.
Why do mortgage lenders require escrow accounts?
Escrow accounts are meant to reduce risk for lenders. They want peace of mind that you’re going to pay your insurance premiums and property taxes on time, and escrow accounts help to streamline that. The idea is that you’ll be less likely to default on your mortgage or have liens put on your property. Your insurance premiums and estimated property tax bill will determine the minimum amount your lender requires you to keep in your escrow account.
What is an escrow analysis?
Insurance premiums and property taxes can change over time. Mortgage lenders perform an annual escrow analysis to ensure that you’re contributing enough to cover those bills when they’re due. You will likely receive a notification from your lender if your monthly payment is going to change.
If there’s a shortage in your account, the deficit amount will be usually divided by 12 and added to your monthly payment. Alternatively, you can make a lump-sum payment to bring your balance up to where it needs to be. That can help prevent your monthly payment from increasing.
What happens if my insurance changes?
Switching to a new homeowners insurance carrier can lead to big savings, which can certainly be worthwhile. Be sure to contact your mortgage lender so they’re up to speed, and don’t disburse any upcoming payments to your previous insurer. After you cancel your old policy, your new insurance company should send the necessary documents to your lender.
If you make the jump before your renewal period ends with your current insurer, you may receive a partial refund. You might want to redirect that money into your escrow account to prevent a shortage. If there is a shortage, your monthly payment will likely increase to cover the difference.
Escrow accounts can make it easier to pay your homeowners insurance and property taxes, which is certainly convenient. You’ll simply make your regular monthly payment, then your mortgage lender should allocate those funds to your escrow account and pay those bills for you when the time comes. If you choose to change your insurance carrier, your minimum escrow account balance will be recalculated based on your new rate.
Matic has you covered
If you’re on the hunt for a new homeowners insurance company, let Matic do the heavy lifting for you. We make it easy to compare policies from top-rated carriers, which could help you keep more money in your pocket.
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