If you have purchased a new home financed with a mortgage or if you are shopping for a new home and a mortgage, you will notice a portion of the house payment goes to the escrow funds or balance. The act of putting money in escrow can be used for a wide range of purposes, usually associated with financial transactions. The escrow money paid with your monthly mortgage payment can only be used in a few specified ways.
TL;DR (Too Long; Didn't Read)
If you have a mortgage, your lender may set up an escrow account, which holds funds for paying your monthly prorated property tax and homeowners insurance payments. If you're buying a home, the lender may hold your earnest money and certain other funds in an escrow account until the closing.
Overview of Escrow
In general, to put money in escrow is to set aside money in a separate account where it is held until a specific transaction is completed. Placing money in escrow protects both parties in a transaction.
The person delivering a product or service knows the money has been set aside to pay when the contract is fulfilled. The buyer or payer shows that she has the money to pay for the contracted transaction.
Escrow deposits are often used to lock in real estate transactions, but escrow deposits can be used for almost any form of contract.
Mortgage Escrow Accounts
A mortgage company sets up escrow payments and a corresponding escrow balance on an individual mortgage to protect the mortgage company's interest in the financed property. The mortgage company uses the escrow money to pay for items to make sure the property retains enough value to pay off the loan if the homeowner is unable to make the payments or if something happens to the property. The items paid with the escrow money are obligations of the homeowner. The mortgage company collects the escrow money to make sure those obligations are paid.
Uses of Escrow Money
The Real Estate Settlement Procedures Act of 1974 dictates what mortgage companies can and cannot do with collected escrow funds. The use of escrow money is limited to the payment of property taxes and hazard insurance premiums. Hazard insurance is your homeowner's policy. If you have flood insurance -- especially if your home is in an area where flood insurance is required -- the mortgage company also will collect escrow money to pay the flood insurance premiums.
Lender-Managed Escrow Account
The escrow payment with each monthly mortgage payment is also a convenience for you as a homeowner. The monthly payment is often easier to budget than trying to make large, once-a-year payments for property insurance and taxes. The mortgage company is allowed to maintain a cushion of no more than one-sixth of the annual escrow payments, or two months of what you pay in your monthly payment.
If the mortgage company has accumulated too much money in your escrow balance, the excess will be paid out to you. The mortgage company will adjust the escrow amount each year to keep the amount collected in line with the current costs for insurance and property taxes.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.