When you make your monthly mortgage payment, you might notice that a large chunk of it doesn't go toward paying down your loan at all. Instead, it goes into an escrow account.

Understanding how escrow works is crucial, as it is the most common reason a fixed-rate mortgage payment unexpectedly increases.

What is an Escrow Account?

An escrow account is essentially a savings account managed by your lender on your behalf.

Instead of trusting you to save up and pay your annual property tax bill and homeowners insurance premium at the end of the year, the lender divides these annual costs by 12 and adds them to your monthly mortgage payment.

The lender deposits that portion of your payment into the escrow account every month. When the tax and insurance bills are due, the lender pays them directly from the escrow account.

Why Do Lenders Require Escrow?

Lenders require escrow to protect their collateral (your home).

  • Property Taxes: If you fail to pay your property taxes, the government can place a tax lien on your home and eventually foreclose on it. A government tax lien supersedes the bank's mortgage lien, meaning the bank could lose their money.
  • Insurance: If your house burns down and you let your insurance lapse, the bank's collateral is destroyed, and they have no way to recover their funds.

By forcing you to pay into escrow monthly, the bank guarantees the taxes and insurance are paid.

The Annual Escrow Analysis

Property taxes and insurance premiums are not fixed; they change over time. Therefore, once a year, your lender will perform an escrow analysis to ensure they are collecting the right amount of money.

Escrow Shortage

If your property taxes or insurance premiums go up, the lender will pay the higher bill, but your escrow account will become depleted. The lender will then notify you of an escrow shortage. To fix this, your monthly payment for the upcoming year will increase to cover the new higher bills, plus an extra amount to replenish the shortage.

Escrow Overage

If taxes or insurance decrease (rare, but it happens), you will have an escrow overage. The lender will issue you a refund check for the extra money and lower your monthly payment for the next year.

Can You Waive Escrow?

If you put at least 20% down on a conventional loan, many lenders will allow you to waive escrow. This means you only pay Principal and Interest to the bank, and you are responsible for paying the tax and insurance bills yourself.

While waiving escrow gives you more control over your cash flow, it requires financial discipline to ensure you have thousands of dollars saved when the tax bill arrives.