Escrow 101: The Ultimate Guide for Homebuyers

Escrow may sound like a foreign word but it’s actually Middle English. It hails from the now-defunct word “escrowl,” which means “checklist” or “scroll.” In today’s real estate terms, escrow can refer to 2 different types of transactions. There’s “purchase escrow” (more on that later) and then there is “mortgage escrow”. Mortgage escrow is an account, typically held by your lender or a third party, that keeps your finances in place to pay your mortgage and other expenses.

A mortgage escrow account is typically made up of: 

• Mortgage payment 

• Property taxes 

• Homeowner’s insurance 

• Private mortgage insurance (PMI) – if applicable

For the most part, everyone will start a housing transaction with a “purchase escrow” account. When it comes to “mortgage escrow” – in some cases, you don’t need an account but this depends on certain factors. Your lender may even require you to hold a mandatory mortgage escrow account depending on your loan. FHA and VA loans tend to require mortgage escrow accounts. Like everything, there are pros and cons when it comes to having a mortgage escrow account. The biggest pro is that you don’t have to do the math when it comes to your mortgage payments. Being a new homeowner can be overwhelming, so it can be nice to have this piece in place.   

On the other hand, mortgage escrow accounts may add to closing costs, tie up your money from investments, and may include maintenance fees. Overall, it really comes down to your choice but as evidenced by the numbers, many homebuyers – especially first-time homebuyers – tend to use mortgage escrow accounts.  

Escrow 101 for First-Time Homebuyers 

Mortgage escrow accounts are popular (if not mandatory) for first time homebuyers because there is a lot going on all at once. Your escrow account isn’t just annoying paperwork. It can be mandatory if you put down less than 20% on a conventional loan, or if you go with FHA or USDA financing. Banks aren’t trying to be control freaks. They just want to make sure you don’t fall behind on property taxes or let your insurance lapse. With FHA loans, they’ll also collect your mortgage insurance this way.

A “purchase escrow” account is created when you and the seller sign a purchase agreement. From there, a real estate agent or you will get your earnest money (basically a good faith deposit) and start your escrow account. If you do not need an escrow account moving forward after your purchase, your escrow account will be closed at the closing of your home. If you still need to maintain an escrow account (mortgage escrow) due to loan obligations or other reasons, this account will continue being kept by your lender or a third-party. This money will sit in an account and the party responsible will pay your bills for you. 

To set up a mortgage escrow account, your lender will calculate your mortgage payment, property taxes, and whatever other monthly expenses come into play like homeowner’s insurance or PMI. They then divide this number by 12 (months in the year). 

Pros and Cons of Escrow Accounts 

Let’s take a look at the pros and cons of having a mortgage escrow account.  

Pros 

• Convenience of bundled payments  

• You don’t have to do the math or figure out how much you owe in taxes 

• Ensures timely payment of taxes and insurance 

• Avoid late fees in case you forget to make a payment 

• Helps with budgeting 

• For the most part the payment stays consistent – only going up yearly depending on property taxes and homeowner’s insurance 

• Protects lenders’ interests 

• Makes sure you stay true to your financial obligations 

Cons 

• Additional monthly costs 

• You must pay for an escrow account, and it is normally factored into your mortgage 

• Lack of control over fund management 

• The money is tied up in the escrow account so you cannot invest it 

• Potential for payment variations 

• You may be able to find more of a deal 

• Interest not earned on held funds 

• The money does just sit in the account not accruing interest 

• Possibility of account shortfalls 

• If the escrow account doesn’t have enough money in it, you may not fulfill all your obligations. 

Alternatives to Mortgage Escrow Accounts 

If you’d like to forego a mortgage escrow account (and are able to), there are options available. You can pay your property taxes and insurance independently of the mortgage. This would be your responsibility to calculate your tax burden and investigate homeowner’s insurance options. If you do not have an escrow account, you could put the money that would go into one into a high yield savings account. This will help grow your money as you wait to pay your mortgage.  

Honestly, if you’re good with your money, know how to budget, and never miss a payment, then it might make sense for you to not hold an escrow account. If you lack financial discipline, then an escrow account is the right way to go.  

Common Escrow Account Mistakes to Avoid 

One of the most common mistakes when it comes to having a mortgage escrow account is not looking at your monthly bill or invoice. This can lead to several issues like not paying enough or overpayment. Even though the company is making the payments, it’s still your responsibility to make sure everything looks correct. 

Other common mistakes include not budgeting for a potential increase, failing to understand where all the escrow payments go, and ignoring property tax reassessments. If you are the kind of person who may need a little assistance or may not be on top of all the paperwork, then an escrow account is for you.   

Escrow Insights

Ultimately, it’s your decision whether you’d like a mortgage escrow account – that is of course if your loan allows for it. The pros of having an escrow account can outweigh the cons, but this does depend on your unique situation.  

If this is your first time buying a home and you’re new to the process, chances are you’ll want an escrow account. However, if you’re making a standard 20-per-cent down payment or feel you don’t need it for other reasons, then maybe it’s not for you. The escrow account should be there to help you, so if you find it’s doing more harm than good, it’s time to reassess. Consult with an escrow agent, lawyer, or financial advisor regarding your specific situation.