What Does an Escrow Account Cover?

Purchasing a home involves expenses other than the mortgage payment. If you're a potential home buyer, be prepared for your money to be moving in a lot of different directions. It's important to realize what the various fees and payments are covering when it comes to your mortgage lender. Escrow accounts are used to cover property taxes and homeowners insurance premiums.

When a mortgage loan is used to purchase a house, the house itself serves as collateral to secure the lender's interest. The lender wants to ensure that no other liens are placed on the property and that the home is insured in the event of an accident or damage. Failure to pay property taxes can result in a tax lien or tax foreclosure. An home damaged in a fire or natural disaster might be too expensive to repair without insurance. These situations are not favorable to the lender, so the escrow account is established to make sure they don't wind up at a loss. Lenders typically require borrowers to start an escrow account if they have less than 20 percent for a down payment.

Once the escrow is established, each month you will pay the lender an additional amount on top of the mortgage payment. The additional amount is placed into your escrow account until property taxes or insurance premiums are due. Your lender will pay the bills directly on your behalf out of the escrow account. The monthly escrow payment is calculated by the lender each year. They analyze property tax rates and the cost of insurance and reach a total. The total is divided by 12 to figure out the monthly obligation. Additionally, lenders might collect a little extra to cover if their estimates fell short. This is usually called the "cushion" and by law the lender can collect only two extra months worth of escrow payments to act as the cushion.

Counties and cities assess property taxes on homes and land. The owner of the property is responsible to pay these taxes as they are due. Property tax rates vary dramatically across the country. However, metropolitan areas are likely to have much higher property taxes than rural areas. The revenue generated from the tax is used to pay for public works projects such as school systems, roadway maintenance and public safety. The tax collector representing your jurisdiction determines the tax rates and the method to assess property values. Over time, your property taxes will change -- generally increasing. Your escrow payments will adjust accordingly.

Homeowners insurance is similar to car insurance, and there are different levels of protection available. At the very minimum is dwelling coverage, which covers only the physical structure of the home. Most mortgage lenders consider this level of protection mandatory. You can opt to increase your level of coverage to include personal property such as furniture and jewelry, or injuries to people who are visiting your home. A regular homeowner's insurance policy covers most natural disasters, except floods. Flood coverage is a completely different policy. Your lender might require flood coverage if you live in an area that is prone to flooding.