When you obtain a mortgage to purchase a home, your lender will most likely require you to put money in escrow. In this article, we'll talk about what a mortgage escrow is and how it works.
An escrow is a contractual arrangement wherein a third party holds the money on behalf of the other two parties in a transaction. This money will be kept in an escrow account and will only be released when the contract agreement has been met.
Usually known as an escrow agent, this third party is not concerned whether the seller or buyer is ahead. Additionally, using a third-party service helps make the transaction between the two parties safer by protecting their assets until they have fulfilled their respective obligations.
There are two purposes for escrow accounts in a mortgage:
(1) To protect the buyer's earnest money; and
(2) To house the homeowner's insurance and property tax payments.
If you make an offer on a home, and the seller accepts it, you'll usually have to provide earnest money.
Earnest money, also known as a good faith deposit, is an amount that shows you have the intent and ability to go through with the purchase. The amount that you provide is usually 1%-3% of the home's purchase price. This money will be kept in an escrow account.
In exchange for the buyer providing earnest money, the seller will take the house off the market. When all the conditions of the transaction have been met, the funds will then be released to the seller as part of the purchase price.
Although earnest money is not a fee, it can be forfeited. If the sale falls through because the buyer decides to withdraw from purchasing, the seller gets to keep the money.
However, if the sale falls through because of certain circumstances, the buyer will get to keep most, if not all, of the earnest money. Examples of these circumstances are the house not passing the home inspection or if the home appraises at a lower value, but the seller doesn't want to lower the purchase price.
After closing, your lender will set up an escrow account. This account will hold a portion of your monthly payments to pay for insurance premiums and property tax.
The primary purpose of this escrow account is to ensure that you consistently pay your obligations on time. Although this might cause you to have higher monthly payments, you wouldn't have to worry about paying the yearly insurance and tax bills.
The amount required for your premium and taxes can change every year. So to ensure that there are enough funds in your escrow account, most lenders would require two month's worth of extra payments.
Lenders would review your escrow account once a year to make sure that they are not collecting too much or too little. If their review shows that they've collected too little, you'll have to cover the difference. But if the analysis indicates that they have accumulated too much, they will give you a refund.
What Escrow Doesn't Cover
Escrow is a handy tool for homeowners, but it won't cover everything. Examples of expenses an escrow won't cover are HOA fees, utility bills, and taxes other than your property tax.
Is Escrow Avoidable?
Although it's possible for homeowners to pay the premiums and property tax themselves, not everyone will have this option. The lender will require an escrow depending on the type of loan you get and your financial profile.
If your down payment is less than 20% for conventional loans, the lender will require you to have an escrow account. For VA loans, you need to have at least a 10% down payment and good credit health to opt out of having an escrow account. And borrowers of FHA loans are all required to have an escrow account.
Who Will Manage Your Escrow Account?
Your lender will manage your escrow bank account. It's the lender's responsibility to make sure that they collect enough and pay your bills on time. If you have missed or late payments, even though you already have an escrow account, your lender will be liable for the penalties.
A mortgage escrow helps simplify your home buying and homeownership experience. Without it, it would be your sole responsibility to ensure those payments are sent accurately and on time to all the parties involved in the transaction.
If you have more questions about mortgages or need help applying for a home loan, our mortgage broker can help you.