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What Is Escrow, And How Does It Work?

Friday, January 14, 2022   /   by Jeff Lovato

What Is Escrow, And How Does It Work?

If you’re buying a home, you’ll probably hear the word “escrow” used repeatedly. Let’s find out  what escrow is, how it works and how it can benefit you as a home buyer, seller or homeowner.
What Is Escrow? 
Escrow is a legal arrangement in which a third party temporarily holds large sums of money or property until a particular condition has been met (such as the fulfillment of a purchase agreement).
It is used in real estate transactions to protect both the buyer and the seller throughout the home buying process. Throughout the term of the mortgage, an escrow account will hold fund’s for taxes and homeowner’s insurance.
The Benefits Of An Escrow Account
The biggest benefit of an escrow account is that you’ll be protected during a real estate transaction – whether you’re the buyer or the seller. It can also protect you as a homeowner, ensuring you have the money to pay for property taxes and homeowners insurance when the bills arrive. You’ll find that there are a few other great benefits for home buyers, owners and lenders, too.
For Home Buyers
An escrow account is key to protecting your deposit during a home sale. For example, say you have a purchase agreement, but the sale falls through due to a problem found during the home inspection. If you’d given your deposit directly to the seller, there’s a chance the seller wouldn’t return your deposit. But since the deposit is being held by a third party, you can be confident it will be returned according to your agreement.
For Homeowners
An escrow account takes the pressure off you to come up with a lump sum to cover taxes and insurance. Since you’re paying for your taxes and insurance throughout the year, the payments are much more manageable.
An added bonus is that you don’t have to keep track of all the different due dates. When your tax bills and insurance premiums are due, your mortgage servicer will make sure those bills are paid on time, every time. That way, you’re not responsible for any late payments. Your servicer will even cover bills for you if your escrow account is short on funds.
For Lenders
Lenders have a vested interest in making sure your property taxes and insurance get paid:
If your tax bills don’t get paid, the tax authority could put a lien on your home – which could end up costing the lender money if the tax authority chooses to foreclose.
If your homeowners insurance coverage lapses, significant damage to or loss of the home means your lender loses money.
Having an escrow account on the loan allows the lender to ensure the bills get paid.
The Disadvantages Of An Escrow Account
When it comes to the disadvantages of an escrow account, it’s the homeowner who encounters most of the burden. Here are some examples:
Higher mortgage payments: As stated before, an escrow account is funded through your monthly mortgage payment, making your monthly bill higher than it would be without escrow.
 
Incorrect estimates: The amount needed for your escrow depends on your property taxes and homeowners insurance costs, which can change from year to year. Your servicer will determine the amount needed based on the previous year’s bills.A significant rise in your property taxes could happen repeatedly for the first few years you live in the home before it steadies. Because of this, your escrow may come up short. If that happens, you’ll have to pay the difference out of your own pocket. But on the other side, if there is any money left over in your escrow after paying the taxes and insurance for the year, your servicer will cut you a check for the excess funds.
Changes to your monthly payment: Escrow is reassessed each year and, depending on if you were short or had excess money, your servicer will come up with a new estimate for the year. If you’re short, your mortgage payment will go up because the estimate will increase.
What Escrow Accounts Don’t Cover
Escrow accounts don’t cover all the expenses related to homeownership. Your lender or servicer won’t collect money to pay your utility bills or HOA fees, for instance.
Supplemental tax bills are also not covered by escrow accounts. These are one-time tax bills that are issued due to a change in ownership or new construction. Your lender can’t predict when you’ll get a supplemental tax bill or how much it will be.
Do You Need An Escrow Account?
It’s possible to pay for property taxes and insurance yourself instead of using an escrow account. Doing so will lower your monthly mortgage payment, but you’ll have to save for tax and insurance payments on your own.
However, not everyone will have the opportunity to opt out of having an escrow account on their loan. Escrow accounts are sometimes a requirement. For VA loans, for example, you’ll need 10% down and a strong credit profile to opt out of having an escrow account. For conventional loans, you’ll need to have a down payment of 20% or more. FHA loans require all borrowers to have an escrow account.
It’s also possible to use your escrow account for some expenses and not others. Sometimes lenders require escrow for property taxes but not homeowners insurance.
The Bottom Line: Escrow Protects Both Buyers And Sellers
Escrow is an important part of purchasing a home. It protects buyers and sellers during home sales, and offers a convenient way for you to pay for your taxes and insurance.
An escrow account is sometimes required, and sometimes it’s not. It depends on the type of loan you get, as well as your financial profile. It may be tempting to go without an escrow account because it could mean a lower monthly mortgage payment – but escrow can provide peace of mind by removing your responsibility to make sure those important bills get paid.
If you feel ready to begin the home buying process, contact us - get started today with The Lovato Group.
The Lovato Group
Jeff Lovato
50 S Steele Street, Suite 700
Denver, CO 80209
720-854-4834

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