The term escrow is used to describe an arrangement whereby a third party receives and disburses monies from another party. In the real estate industry, an escrow account is a trust held in the name of a borrower, which is used to pay obligations such as private mortgage insurance, homeowner's insurance, and real estate or property taxes.
The most commonly encountered example of escrow involves transactions between a borrower and their mortgage company. Under these conditions, the escrow account monies are collected monthly, along with the mortgage payments. This arrangement makes it easier for the homeowner to budget for the amounts owed. It also provides the mortgage company with a mechanism to ensure insurance premiums and taxes are paid on the property.
Allowing mortgage companies to control escrow accounts lowers the risk of non-payment on these obligations or insurance shortfalls. This mechanism effectively lowers the overall risk of the mortgage, enabling the lender to offer lower interest rates to the consumer.
The amount of money needed in an escrow account is constantly calculated, and evaluated, by the mortgage company. As property taxes and insurance costs change over time, adjustments are made to mortgage payments to account for shortfalls or overages in the escrow account.
When the principal of a loan is repaid in full, the balance in the escrow account is returned to the borrower.