What is escrow on a mortgage and why is it part of the monthly payment?
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When you agreed to take out a mortgage on your house, you also made an agreement with your bank that you’d insure it and you’d pay taxes on it. Typically, those bills are due every 6 months or a year; to make it easier, the bank allows you to put a little money aside into an account for these bills so that when the bills are due, you don’t all of the sudden have to come up with money to pay a $3000 bill. The money is already set aside.
Just to clarify: there’s no requirement to do this. You can just pay taxes and insurance yourself and doing so is technically the better option. Many people just don’t want the hassle though so they combine it all into one payment.
Escrow just means someone else is holding money for you.
In this case, it’s likely money for property tax and/or insurance. The bank has lent you money to buy a home, and if you fail to repay the money they will take the home away from you. Most people understand that.
But property taxes also need to be paid, and if you fail to pay your property tax the government will come and take the property away. This is a concern for the bank, because if the government takes the property away the bank will be unable to take the property. And it’s highly unlikely that you are going to keep paying a mortgage payment on a property that the government has taken away.
So to solve this problem the bank wants to make 100% sure that the property taxes are being paid. There’s lots of ways that they could do it, but the easiest is just to collect the property tax money from you, and send it to the government. That way if you fail to pay, they know right away, well before the government will come take the property.
That’s normally the monthly escrow payment included in your mortgage. It’s the bank collecting the property tax in advance, then paying it to the government so that they won’t get the home taken out from under them.
They sometimes do the same thing with insurance, for the same reasons. If you fail to insure the house, then it burns down, you’re not going to want to pay the mortgage anymore but the property is worth a lot less so the bank can’t take it away from you to sell it to recover the loan. So they do the same deal that they do with property taxes, they charge you in advance, then pay the insurance for you that way they know it’s been properly taken care of.
Often you can arrange to do these things yourself, but it’ll make the bank a little uncomfortable for obvious reasons (they don’t entirely trust that you’re going to actually DO it). And if you fail to pay the taxes or insurance, you’ll screw both yourself and the bank. The bank does not really care if you screw yourself but they care a lot if you screw the bank.
Escrow is an account that holds money relevant to the mortgage property, but is not owed to the bank. It is most common to hold future payments of property insurance and property taxes. A very typical setup is that the escrow receives a portion of each monthly payment and then disburses to cover property insurance and property tax payments maybe every three, six, or twelve months depending on the terms. Escrow is often required by the lending institution because insurance is required by them to protect the property against losses, and property taxes must be paid on the property or else the government will have a claim against the property. If the mortgage is paid off the escrow goes away and maintaining the insurance and taxes is solely up the owner to arrange.
An escrow account also accrues interest on the money in the account and pays out to the property owner.
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