How Escrow Accounts Work

During the home buying process, you may be unclear on what an escrow account is and why you’re paying for one. Here’s what you need to know about escrow accounts.

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Anybody with a mortgage likely has an escrow account. What does this mean and why are you paying for one? Today I’d like to discuss everything you need to know about escrow accounts and why you have one.

I think that people tend to confuse escrow accounts with earnest money. Earnest money is good-faith money that you put down when you make an offer on a home to let the seller know that you’re serious about the purchase. This money, paid at closing, gets applied toward your down payment, so it’s not necessarily additional money.

Let’s say that you buy a home for $150,000 and you put $1,000 down in earnest money. This does not mean that you’re now paying $151,000; that $1,000 is going to the seller and the seller’s broker and is held until closing. At closing, that money is applied toward the rest of the purchase, so you would only bring $149,000 to the closing.

While earnest money is part of the offer process, at this point in the home buying process, you’ve closed on the property and you now have what is called an escrow account. The escrow account is set up with your lender to pay your taxes and homeowners insurance. It is an account into which you will deposit money so that the lender can pay these two things for you.

The reason for an escrow account is because the lender wants to make sure that if they are lending you $150,000 for a property, you have insurance on it and are keeping up with your taxes.

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An escrow account is different from an earnest money deposit.

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Why is the lender concerned about these two things? For one, the lender wants to make sure that your home will be able to be rebuilt in the event of a natural disaster like a tornado.

Secondly, the lender wants to make sure that you’re paying your taxes because the government has first-lien rights on your home. This means that if you were to stop making mortgage payments, the government is in line first to get their money back on your property before the bank. This puts the bank in a second-lien position, which they do not want to be in, so they build this into your escrow account.

Also, when you get pre-approved for a mortgage, your approval is based on PITI, or the principal and interest plus taxes and insurance. If you’re taking out a loan from one property to the next, even if you’re borrowing the same amount of money, your monthly payment can differ based on the taxes and insurance for each property.

Remember, what you see on TV about “opening escrow” is much different from how we handle escrow in the Midwest. If you have any other questions about escrow accounts or the home buying process, please reach out to us by phone or email. We’d be happy to help you!