Mortgage escrow accounts explained: property taxes, homeowners insurance, and why payments change

What is a mortgage escrow account?

An escrow account (sometimes called an impound account) is a separate account managed by your loan servicer. Along with your principal and interest, each month you pay one-twelfth of your estimated annual property taxes and homeowners insurance premium (plus mortgage insurance and flood insurance if applicable). The servicer holds the money and pays the tax authority and insurance company on your behalf when the bills come due. Lenders like escrow because unpaid taxes or lapsed insurance put their collateral at risk.

Do not confuse this with "escrow" in a home purchase, where a neutral third party, often a title or escrow company, holds the earnest money and closing documents until the transaction closes.

What does a typical escrow payment look like?

With 10% down at 7.03%, principal and interest is about $2,577, so the full payment is about $3,137, plus any mortgage insurance. Estimate your own.

How does escrow work at closing?

At closing you fund the account's initial deposit, which is part of your closing costs. It typically covers several months of taxes and insurance, so the servicer has enough on hand when the first bills arrive, plus a cushion. You also usually prepay the first year of homeowners insurance and some interest. See the closing cost breakdown. Federal rules generally allow servicers to keep a cushion of no more than two months of escrow payments.

Why does my mortgage payment change if I have a fixed rate?

A fixed-rate loan fixes principal and interest, but not escrow. Your payment can change when:

• Property taxes rise because your home was reassessed, the local tax rate increased, or an exemption expired.
• Homeowners insurance premiums rise, which has been common in recent years in many areas.
• Mortgage insurance changes or is removed. When PMI ends.
• The servicer corrects a shortage after an annual review.

What is an escrow analysis and an escrow shortage?

Once a year the servicer performs an escrow analysis: it compares what it collected with what it paid out and projects the next year's bills. The result can be:

• Shortage: the account has less than it should. You can usually pay it in a lump sum or spread it over 12 months.
• Surplus: you overpaid. If the surplus is $50 or more, the servicer generally must refund it within 30 days.
• Deficiency: the account is negative because the servicer paid a bill before it had enough. It is also collected from you.

Property taxes: how they work

Local governments assess your property's value and apply a tax rate (sometimes called a mill rate) to set your bill. National averages are about 1% of a home's value, but they range from under 0.5% in some places to over 2% in others. Reassessments after a sale can raise your taxes noticeably, so ask an agent about how your area handles them. To reduce your taxes:

• Apply for exemptions, such as a homestead exemption, and for senior, veteran, or disability breaks where available.
• Appeal your assessment if it seems too high compared with similar homes. There is a deadline, and it often costs little.
• Check the bill for errors in square footage, bedrooms, or land size.

Homeowners insurance: what it covers

A standard homeowners policy covers the dwelling, other structures such as a garage, personal belongings, liability, and additional living expenses if you cannot live in the home after a covered loss. It usually excludes floods and earthquakes, which require separate coverage. Lenders require a policy that covers at least the loan amount or the replacement cost. If the home is in a designated special flood hazard area, a federally backed loan requires flood insurance, and premiums are added to escrow. Check flood risk at FloodSmart.gov.

If you let your policy lapse, the servicer can buy "force-placed" insurance, which is usually much more expensive and covers the lender's interest more than yours. Keep your coverage current and send proof if you change carriers.

Ways to keep insurance costs down: compare quotes every year, raise your deductible if you have savings to cover it, bundle policies, ask about discounts for security systems, new roofs, or storm protection, and maintain a good credit history where allowed.

Can you opt out of escrow?

Sometimes. Many lenders waive escrow for borrowers who put down 20% or more and meet other conditions, and some charge a fee or a slightly higher rate. FHA and USDA loans require escrow, most VA lenders require it too, and it is mandatory for higher-priced mortgages for at least the first five years. Without escrow you pay taxes and insurance directly, which gives you control of the money, but you must budget for large bills. Missing one can create lien and coverage risks.

How to keep an eye on your escrow account

1. Read your annual escrow statement: check taxes and insurance amounts against your actual bills.
2. If your servicer pays the wrong amount or a bill late, ask for a correction in writing.
3. Send your servicer a copy of new insurance policies and any changes.
4. Ask about spreading a shortage over 12 months.
5. Plan for increases: a rise in taxes or insurance is a normal part of homeownership, so leave some room in your budget. How to budget for a home.

Questions to ask about property taxes before you buy

1. What are the current annual property taxes, and what will they be after the sale? Some places reassess at sale price.
2. What is the local tax rate, and what exemptions can I claim?
3. Are there special assessments or bonds on the property, such as for roads or utilities?
4. How often does the area reassess, and how have taxes changed in recent years?
5. Are there any unpaid taxes or liens the title company should resolve?

Escrow when you refinance or sell

When you refinance, your old servicer refunds your old escrow balance within a few weeks after payoff, and you fund a new escrow account at closing. When you sell, the servicer returns any remaining escrow balance after the loan is paid off, and property taxes are usually prorated between you and the buyer at closing. Keep your servicer's contact information and check that the refund arrives.

Escrow checklist for new homeowners

• Confirm your servicer has your correct insurance policy and mortgage clause.
• Note the dates when property tax bills are due and check that your servicer paid them.
• Review your first escrow statement and compare it with your actual bills.
• Set a yearly reminder to shop insurance quotes and review your tax assessment.
• Keep an emergency fund for a possible escrow shortage or a mid-year tax increase.