Escrow Accounts

If you're thinking about buying a home then you should be familiar with the concept of escrow.  In fact, when buying a new home, the money placed in an escrow account is oftentimes the largest expense associated with a home's closing cost.

In this article we're going to provide a thorough explanation of the concept of escrow including a brief definition, the purposes of these accounts and we'll finish up with some examples including a link to our online escrow calculator.

What is Escrow?

While most of us associate escrow with the purchase of a home, it's better to define it more broadly as a legal agreement that involves the deposit or delivery of an asset - usually money - to a third party that is known as an escrow agent.  That agent is responsible for carrying out the instructions that exist between two or more parties.

The money held by the escrow agent is kept in a trust until certain conditions are met.  Once those conditions are satisfied, the escrow agent will deliver the asset to its rightful owner.  Until then, the agent is bound by their fiduciary responsibilities to keep and maintain the escrow account.

Real Estate / Mortgage Escrow

When you close on a home, your lender, bank or mortgage company will usually require you to establish an escrow account.  The money deposited into this account is then used to pay for expenses such as real estate / property taxes, homeowners insurance, and even flood insurance (if required).

The escrow protects the lender by ensuring sufficient funds always exist to pay both the taxes and insurance premiums in a timely fashion.  Essentially, the escrow account helps protect the investment the mortgage company has in your home until the loan is satisfied.

Escrow Due at Closing

An escrow account is usually established at a home closing.  This is where the initial deposit into the account frequently takes place. Later on we'll discuss the calculations used to figure out exactly how much money is needed to satisfy this initial deposit into the escrow account.

Monthly Escrow Payments

Each month your lender will require you to make subsequent payments into your escrow account.  These payments are usually added directly to, and collected along with, your monthly mortgage payment.  In other words, your mortgage payment will likely be the sum of payments on principal, interest, taxes, insurance and private mortgage insurance / PMI (if needed).

Payments from Escrow

The escrow agent will hold and collect money each month, but they're also responsible for making payments from the escrow account.  The agent will send real estate / property tax payment directly to the government agency responsible for collecting taxes.  The agent will also make payments on your homeowners insurance policy as the premiums come due.

Escrow Calculations

Most of the time lenders structure escrow accounts with a built in cushion.  So if you are late with a payment your lender can stall pay the taxes or insurance on time.  That being said, the Real Estate Settlement Procedures Act (RESPA) limits the amount of money the lender may require for the payment of taxes and / or insurance.

RESPA limits lenders to a cushion equal to on-sixth of the total expenses paid from the escrow account - which from a practical standpoint is equal to two monthly payments.  Some states or lender may allow for a lesser amount, but the cushion limit, or maximum, is two months of escrow payments.

Calculating Escrow Values

To calculate the initial and monthly escrow payments we only require about four pieces of data:

• Annual Property / Real Estate Taxes
• Annual Flood Insurance Premiums 
• Homeowners Insurance Premiums
• Number of Months Before the First Payment

The first three elements are used to calculate the total amount of expenses paid from the escrow account each year.  The final element - the number of months before the first payment - is used to calculate the starting balance of the escrow account.

Example Escrow Calculations

In this example our property taxes are $5,000 per year, we're playing flood insurance of $300 per year and the homeowners insurance premium is $1,200.  The first quarterly tax payment is due in just one month.  This means that a total of $6,500 in expenses is paid from the escrow account each year.

We also know that our starting escrow balance is $1,791.67 and our monthly payments would be $541.67.  The minimum balance is equal to twice the monthly payment or $1,083.33.

The payment pattern into and from the escrow account along with the balance in the account appear on the following table:

Escrow Example Table 1

Online Escrow Calculator

If you're interested in running through some additional examples then you should take a look at our online escrow calculator.  There you'll be able to run through numerous examples.  And just like the example above, our online calculator will figure out your monthly payment, minimum, starting and even a theoretical maximum account balance.

As is the case with all of our online tools, our escrow calculator comes complete with instructions as well as information on how to interpret the results.

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