When you buy a home, your monthly payment includes the amount going to pay off the mortgage and a small portion to cover your homeowner’s insurance and property taxes. The money to pay your insurance and taxes goes into what is called an escrow account.

Escrow is a convenient way to make sure your taxes and insurance are paid fully and on time. An escrow account may also be used for other purposes, such as the payment of homeowners fees, but it’s primarily for taxes and insurance.

How Escrow Works

When you’re buying your home, you must also purchase homeowner’s insurance. And before you close on the purchase, you’ll know what your insurance premium will be for at least the first year.

Likewise, you’ll know what the estimated tax bill will be for that property. By adding the insurance costs and taxes on the property and dividing that figure by 12 you will get your monthly escrow payment.

For example, if your property taxes and other assessments total $4,000 and your homeowner’s insurance is $2,000, your annual escrow account should contain at least $6,000 and your monthly mortgage payment would include $500 to go into escrow.

Then your insurance company should send invoices to the bank managing your escrow account and your bank should pay the insurance company on time. The same is true for your local taxing authority, which should send tax bills to your bank for payments to come from your escrow account.

You will likely be copied on your insurance and tax bills; it’s a good idea to monitor your escrow account to make sure everyone is getting paid.

Surplus, Shortfalls and Slip-ups with Escrow

Because escrow accounts are adjusted annually based on estimates of tax bills and insurance premiums, there is always a chance that you will end the year with extra money in your escrow account or you will come up short. If you have extra money in your escrow account, most states require that the additional funds be returned to you, the homeowner.

It might be more convenient to simply leave the extra money in the escrow account for the following year. But these accounts are regulated and the institutions must follow the rules. You can always set aside any overages from one year to the next just to redeposit them in your escrow account or use those funds to help pay down your mortgage.

On the other hand, you may also end up with a shortfall at the end of the year and have to put money into your escrow account that you didn’t plan on spending. This shouldn’t be a large figure, but it can’t be ignored since you could incur penalties for late payments or non-payments of your taxes and insurance premiums. You also run the risk of being dropped by your insurance carrier, so make sure you clear up any discrepancies quickly.

You may also get a notice that your insurance premium is due by a certain date, suggesting that your escrow account has somehow not paid the premium. In many cases, such notices are sent out well in advance of your payment deadline and the insurance company will get its funds from escrow without a hitch.

Still, it never hurts to follow up with your lending institution to make sure everything is okay with your escrow account and that the bank has all the updated information from the taxing authority and your insurance carrier.

Escrow’s Other Meaning

An escrow account can also be a temporary account established during a real estate transaction. A neutral third party, other than the buyer or seller, can serve as an escrow officer who manages money placed in the escrow account.

For example, if the sale of a home is contingent upon the building passing an inspection or other circumstances, the buyer and seller may agree to have the purchase amount placed in escrow until all conditions have been met. At closing, the escrow officer may release the funds to the seller.

Obviously, the lending institution and other parties are typically involved in setting up such an escrow account. A real estate broker may recommend an escrow officer to the buyer and seller, who need to agree on the person or institution managing the escrow account.