In real estate, an escrow account is a separate bank account used by your lender to pay your property taxes and insurance.
Here’s how it works: You make monthly payments into the account at the same time you make your mortgage payment. Your lender manages the money and disburses the tax and insurance payments when they’re due.
Lenders often require escrow accounts as a way to protect their loan. If you were to fall behind on your property taxes, your home may be subject to a government lien and the lender’s stake in your property would be at risk. Similarly, if you failed to pay your homeowners insurance and disaster struck, the value of your property would evaporate, along with the lender’s investment. An escrow account ensures (for the lender) that your property is properly protected.
It can also benefit you as a consumer. For many people, an escrow account is the right choice; it’s easy to use, it simplifies your saving process and it’s relatively worry-free.
The Advantages of an Escrow Account
- It’s a built-in savings mechanism. Property taxes are usually due only once or twice a year. This means that after months of making no payment, you’ll be expected to pay several thousand dollars to your local government. If you haven’t been diligently saving for this, it’s easy to be caught without the necessary funds. An escrow account equalizes your payments into regular, required monthly chunks.
- It means less worry for you. The bank takes on the responsibility of making sure your taxes and insurance are paid in time and in full. If there are any mistakes made, your lender is legally required to pay the associated penalties and rectify the situation.
- It’s easier to get a mortgage. Many lenders won’t offer a mortgage unless you agree to an escrow. It’s how they protect their investment. So, often, if you want the most options and best rates, you have to be willing to accept an escrow account.
That said, for certain people, an escrow account is burdensome because it ties up their money. And, even if an escrow account is right for you, you should know about some of the cons.
The Disadvantages of an Escrow Account
- You have to pay upfront. With interest rates as low as they are, this doesn’t seem like a big deal. But imagine if you could get a 5 percent return in a money market account (it’s hard to imagine right now, but it’s happened before).That’s a return that you would forgo by forking over your monthly payments to the lender. In other words, you could be investing your monthly escrow payment until the actual tax payment is due – which is what your lender is doing. (Note: Some states require that your lender pay interest to you for the money kept in your escrow account. Check with your lender to see if this is the case in your state.)
- It’s a perpetual cushion that you can’t access. The Real Estate Settlement Procedures Act (RESPA) allows lenders to keep up to two months’ cushion in your account, in case property tax or insurance rates go up. This means that some of your money will be sitting in the escrow account indefinitely, until you either sell the property or pay off your loan. (Of course, should your property tax bill jump significantly, the cushion can reduce or totally cover the pain of an unexpected extra payment – that’s the benefit.)
- It results in less nimble money management. Here’s a scenario: You successfully contest your property assessment and your tax bill goes down. You’ll get some money back, right? Well, yes and no. By law, your lender needs to assess your monthly payments at least once a year, so eventually you’ll get the money back in the form of reduced monthly payments or a rebate check. But it may take quite a long time to happen. Or, on the flip side, if tax bill increases 30 percent, your monthly payments will jump significantly and you may need to make an unexpected lump payment. So don’t let the ease of an escrow account lull you into a false sense of security – always have some extra money saved for unexpected home-related repairs and expenses.
All told, an escrow account is the right choice for most people, but if you’re a capable saver, savvy investor and are comfortable paying your own tax and insurance bills, you may want to avoid one if you can. Not having an escrow gives you more flexibility and more access to your money, even if it does come with some extra work. Learn more about how escrow works.