Grasping all the financial arrangements surrounding your home purchase can be a little daunting. Once you’ve qualified for one of the six available types of mortgages and chosen a fixed or variable interest rate, you’ll be faced with escrow commitments.
The word escrow originated from the 16th-century Old French word escroe, meaning parchment. In Middle English, it evolved into escrowl (now escrow), meaning scroll, eventually referring to a deed, contract or other instrument kept in the custody of a third party. Six hundred years later, the original concept is very much alive in all real estate transactions. Escrow is often misunderstood, so let’s clarify where it fits into both the home-purchasing process and your mortgage.
So, what exactly is escrow?
An escrow is an arrangement made between a buyer and a seller of property whereby an impartial third party receives and disburses money or documents for the transacting parties, with the timing of those payments and transfers dependent on conditions agreed to by those parties. It’s designed to protect both the buyer and seller. To protect consumers in real estate deals, the Texas Department of Insurance requires escrow procedures.
When you make an offer on a home, your agent will fill out a standard, legally binding Purchase and Sale Agreement (PSA) that contains a section detailing the amount of your deposit, known as earnest money, that will be placed in an escrow account. The PSA names the entity (usually an attorney or title company) responsible for establishing and managing an escrow account where the money can’t be touched by either the buyer or the seller. When a seller agrees to your offer, the money remains in escrow until the closing date, when it will be credited, minus fees, to your down payment. Escrow costs can be split between the buyer and the seller; they generally amount to 1–2% of the sale price, and companies often charge a small additional flat fee. The escrow account protects your earnest fees. In the event that the seller does not meet the conditions set out in the PSA, preventing the sale from closing, your deposit will be returned. A list of certified escrow agents can be obtained through the Texas Department of Insurance.
What is escrow on a mortgage?
Your type of mortgage will determine whether or not mortgage escrow is compulsory or optional. If you have a conventional mortgage with a 20-percent down payment, you’re not required to have an escrow account. However, if you’re putting down less than 20 percent on a home or are carrying other types of loans, such as those backed by the Veterans Administration (VA) or the Federal Housing Administration (FHA), you will be required to set up an escrow account at closing. A mortgage escrow protects both the lender and the homeowner.
What is an escrow account?
Funds are placed in an escrow account and are used to pay the annual property taxes and insurance premiums on your behalf, as they become due. This process is initiated by the lender, who orders a tax service to set up the escrow account and calculate how much needs to be collected each month from you, based on your projected annual property tax and insurance costs. The funds are paid out of your escrow account as the bills come due.
How is mortgage escrow calculated?
You’ll be required to maintain a cushion in your escrow account to cover any unforeseen increases in taxes or insurance, as well as any discrepancies in the monthly payments collected. This cushion is typically equal to two months’ worth of escrow payments. For example, if your monthly escrow payment is $300, you’ll need to have $600 in your account at all times.
When you sell your home, any funds left in your escrow account will be refunded to you, minus any outstanding property taxes or insurance payments that were due and payable during the time you owned the home.
While having an escrow account may seem like an inconvenience, it’s a good thing. It protects you from lapses in property tax and in insurance payments.
Mortgage escrow is calculated by adding your annual property taxes and insurance premiums together, then dividing that number by 12. So, if your annual property taxes are $2,000 and your annual insurance premium is $1,000, your monthly escrow payment would be $333.33. Should your property taxes increase, your lender will cover the increase and recover the difference from you through an increase in your monthly payments. At closing, most lenders require a deposit of two months’ worth of escrow payments into your escrow account. So, using the example above, you would need to deposit $666.66 into your escrow account at closing.
Your monthly mortgage payment will be higher if you have an escrow account, because it will include your monthly principal and interest payments, as well as your monthly escrow payment. For lenders, escrow protects their interest in your property, while for you it’s collateral for your mortgage.
If you have a conventional mortgage, you can choose whether you want your lender to open an escrow account. Lenders may offer buyers in the conventional category, who opt for an escrow account, an interest-rate reduction, since it provides reassurance that prompt payments will be made for property taxes and insurance. Furthermore, if you’re not adept at setting aside money, an escrow account removes that responsibility. Conversely, conventional-mortgage holders may choose to deposit money into their own interest-bearing accounts, since escrow accounts do not yield interest. An expert agent will help you make the decision that best suits your needs.
The bottom line: Escrow protects everyone’s interests
The 16th-century concept of escrow has survived the centuries because it provides robust protection for all interested parties in real estate transactions. With a full understanding of the escrow process, buyers can be properly prepared for their largest financial investment. Briggs Freeman Sotheby’s International Realty has more than 60 years of experience navigating the real estate waters. Our agents are here to help you through your real estate transaction — and guide you toward a smooth and successful journey to your new home.