"Escrow" is an arcane-sounding term for a simple concept. You pay your lender a monthly amount to cover some key housing bills, usually including property taxes and insurance. The lender holds your payments in trust -- or escrow -- then pays the bills when they come due. If it sounds complicated, don't worry. Once you learn how to budget for your escrow, you will see how simple it really is.
TL;DR (Too Long; Didn't Read)
The amount each person should have in escrow is different. It should, however, be enough to cover important things like property taxes and homeowners insurance.
What Your Escrow Includes
To make your budget, you will need to know the total amount due for items being paid from your escrow account. These items are often property taxes and homeowner's insurance. If you have private mortgage insurance on your loan, this may be in escrow as well. The lender doesn't typically require a specific amount to be in your account at a time; rather you pay monthly. In addition to these fees, lenders usually keep a little extra in the escrow account to cover any changes to the estimated bills. Often your monthly payments to the escrow account are rolled into your mortgage payment.
Why Banks Often Require Escrow
In most situations, your lender requires you to have an escrow account, although if you are able to pay more than 20 percent of the asking price as a down payment, you might be able to opt out of the escrow; it depends on the lender's policies. The lender will typically order an escrow account because it wants to make sure your key housing fees are covered. Otherwise, your failure to pay property taxes could result in a tax lien getting slapped on the house, which would threaten the lender's own rights to the property. Or your failure to pay insurance premiums could result in a loss of coverage, which would leave the lender with nothing to foreclose upon if the place burns down.
Estimating Fees
Your monthly escrow payment is easily calculated by taking the total amount due for the year and dividing it by 12. For example, say your property taxes are $2,000 a year and the insurance premium is $400, equaling $2,400. Over 12 months, the payments would be $200 a month. Lenders are allowed to hold up to two more months as a cushion. Using the example, the maximum amount the cushion could be is $400. If you're not sure what your property taxes or premiums will be, contact your tax collector and insurance companies for a quote.
Yearly Recalculations
Don't be alarmed if your escrow payments increase over time. This happens because of changes in the property taxes and insurance premiums. The frequency that the changes occur depends on how often your tax collector reassesses and how often your policy is examined. The lender analyzes your escrow account each year and sends a ledger of all the activity on the account to you. They also include the projected payments for the upcoming year based on their estimates.
Additional Considerations
It's also not uncommon for your closing costs to include a portion for escrow. If you close on your loan in July and a tax installment is due in August, the lender might require the money up front. This depends on the lender and should be disclosed to you in the settlement statement. Sometimes the actual costs are more than expected, and your escrow account is short. Often, the lender will cover the difference for you. Afterward, you will get a notification regarding the deficiency. You usually have the option to pay it off or spread it out over the next 12 months.