How Are Property Taxes Paid Through an Escrow Account?

In a typical escrow arrangement, your monthly mortgage payment is made up of four things: principal, interest, taxes and insurance. Principal is the money you borrowers and are paying back, and interest is the "fee" you pay for the privilege of borrowing that money. Principal and interest go to the bank. The tax portion of your monthly payment is property taxes. It's typically one-twelfth of your annual property tax bill. The insurance portion pays for your homeowner's insurance; it's also usually one-twelfth of your annual premium.

Each month, your lender takes the tax and insurance portions of your monthly payment and sets them aside in a special account, known as escrow. The money sits there until a tax or insurance bill comes due. When that time comes, there should be enough money in the account to pay the bill, since you've been adding to the account every month. The taxing agency and the insurance company bill the lender directly, and it pays those bills on your behalf out of the money in escrow. You may get a copy of the bill, too, just for your information.

At your closing -- the legal proceeding at which you formally buy the home -- you'll usually have to make an initial deposit into escrow for property taxes. Depending on when your closing occurs and when your first tax payment will be due, this deposit might be a little bit of money or a lot. Say you close in January, and the first property tax bill is due to arrive in March. There's not enough time for you to sufficiently build up the escrow account with monthly payments of one-twelfth of the annual tax bill, so the lender requires an initial deposit to get the escrow account "caught up."

Guess what: Property taxes go up and, sometimes, down. Once a year, your lender will take a look at your escrow account to see whether you're putting in enough money to cover your taxes (and your insurance), taking into account any increases that may have happened. This "escrow analysis" usually results in an adjustment to your monthly escrow amount to cover any shortfalls and keep you on track toward your next bill. Lenders usually also require escrow accounts to maintain a "cushion" in case a bill comes in a little higher than expected. Federal law limits the cushion to one-sixth of the total annual expenses paid out of escrow -- an amount equal to about two months' worth of escrow payments. Your annual escrow adjustment may also involve refilling a depleted cushion.