Escrow is a legal arrangement during a real estate transaction in which a neutral third party temporarily holds designated funds and then disperses those funds according to a contractual agreement.

  • Escrow accounts are often used in real estate to keep the buyer’s deposit secure during a home purchase and to manage critical homeownership expenses, including property taxes and insurance throughout the loan repayment term.   
  • An earnest money escrow account allows the buyer to transfer their earnest money deposit to a neutral third party for safekeeping while the transaction is processed. Upon closing or termination of the deal, the third party releases the funds as instructed by the purchase contract.  
  • A mortgage escrow account (impound account) allows homeowners to include amounts for property taxes and insurance in their monthly mortgage payments. The lender or loan service provider uses these funds to pay tax and insurance bills as they come due. 

Homebuyers and homeowners often rely on escrow accounts to manage funds throughout the purchase and during the mortgage loan repayment term. But there is some confusion about how escrow accounts work and when they are needed. This article explains how buyers and homeowners can use escrow accounts to keep funds secure and more efficiently manage some of the most important homeownership expenses.  

What Is Escrow in Real Estate? 

Escrow is a legal arrangement in which a third party holds and distributes funds in accordance with a signed contract. 

There are two common types of escrow accounts in real estate: 

  1. Earnest money escrow (also called good faith deposit escrow). Homebuyers typically encounter the earnest money deposit escrow when their offer to purchase a home is accepted by the seller. The buyer is typically expected to put down a deposit of around 1-2% of the purchase price (the amount varies by market)[1] to show the seller that they are serious about purchasing the home. The funds are held in the escrow account until the deal either closes or is terminated.
  2. Mortgage escrow. Homeowners may encounter mortgage escrow when using a home loan to finance a real estate purchase. Lenders may require that a homeowner’s monthly mortgage payment include the estimated cost of necessities, like property taxes and homeowners insurance.[2] These funds are held in a mortgage escrow account (sometimes called an impound account) until the bills become due. At that time, the bills will be paid out of the escrow balance by the third party.

Whether an earnest money escrow or a mortgage escrow, the purpose of the escrow account is to ensure the funds are available to be distributed to the appropriate parties in accordance with a signed contract.

How Does Escrow Work?

Escrow works by having a designated party hold funds and distribute those funds to the appropriate parties as described in the governing contract.

How Earnest Money Escrow Works (in a Purchase Agreement)

An earnest money escrow account is governed by the purchase agreement for a home. Purchase agreements outline agreed-upon terms for the transfer of a property, including:

  1. Purchase price
  2. Earnest money deposit amount
  3. Means of terminating the contract

Purchase contracts instruct the escrow officer on how to distribute funds based on certain contract terms being met. For example, if the buyer cannot secure funding for the home loan and is forced to cancel the contract within the allotted time frame, the contract may state that the deposit is to be refunded to the buyer. Or, if the buyer backs out of the deal without just cause, the contract may dictate that the deposit be released to the sellers as a remedy for the time their home had been off the market. The contract also explains who should receive the deposit if the purchase goes as planned.

Once the funds are dispersed, the escrow account is closed.

How Mortgage Escrow Works (in a Loan Account)

In addition to the principal and interest on your home loan, many lenders require that monthly mortgage payments include an amount for necessities like property taxes, homeowners insurance (including hazard insurance), and any required mortgage insurance. This escrow arrangement, which is governed by the loan agreement, allows lenders to ensure that these important expenses are paid promptly, which protects the lender’s financial interest in the property.

The lender or a loan service provider estimates these expenses (based on current rates set by taxing authorities and insurance companies) for the coming year and divides the estimates by 12 to arrive at the monthly payment amount.[2] Each month, the homeowner pays the amount on their mortgage statement, and the calculated amounts for taxes and insurance are held in an escrow account. When insurance premiums and tax bills come due, the bills are paid out of the escrow balance.

This process is repeated annually to account for changes in property taxes and insurance premiums. 

The mortgage escrow account remains open for the loan term or until the lender and borrower agree to close the escrow account and have the borrower pay the expenses directly.

What Is Included (and Not Included) in Mortgage Escrow

Mortgage escrow commonly includes:

  • Property taxes
  • Homeowners insurance premiums
  • Any required flood insurance 
  • Any required mortgage insurance (such as private mortgage insurance (PMI) for conventional loans or mortgage insurance premiums (MIP) for FHA loans)  

Mortgage escrow does not typically include:

  • Any homeowner’s association (HOA) dues
  • Utilities (water, sewer, trash, electric, cable, phone, or internet)
  • Home maintenance or home repair expenses

How the Annual Escrow Analysis Can Affect Mortgage Payments

Each year, the escrow service provider completes an escrow analysis to determine if they are holding enough money to cover the tax and insurance expenses for the year. 

If the actual expenses for the previous year were less than the estimated amounts, the borrower may have a surplus and be entitled to a refund. If the actual expenses were more than the estimated amounts, the borrower may need to either repay the difference in a lump sum or increase their monthly mortgage payments over the next year to repay that shortage (depending on the policies outlined in the loan agreement).

Importantly, the annual escrow analysis also determines mortgage payment amounts for the upcoming year. If tax and insurance expenses have increased (which is common as these costs are subject to inflation), the mortgage payment will likely increase accordingly.

Scenarios When a Mortgage Escrow Account May Be Required

Lenders may require a mortgage account for any home loan borrowers, but it is particularly common to see mortgage escrow requirements in the following scenarios:

  1. When the borrower chooses a non-conventional loan. FHA Loans and VA loans, for example, may require an escrow account 
  2. When the borrower has a high loan-to-value (LTV) ratio. The loan-to-value ratio shows how much of the property is financed, as a percentage of the property's value. For example, if a homebuyer makes a 20% down payment, the LTV is 80%. Loans with an LTV of more than 80% may require a mortgage escrow account.   

Can You Manage Escrow Yourself?

Some lenders may allow a homeowner to waive the escrow account and pay taxes and insurance on their own. However, this might only be an option if:

  • You have a conventional loan, 
  • Your loan-to-value ratio is under 80%, and 
  • You have a strong credit profile and payment history.

Who Manages the Escrow Account?

Earnest money escrow accounts are handled by any third party that the buyer and seller agree upon. This could be an escrow officer, attorney, real estate brokerage, or title Company.[1] Mortgage escrow accounts are handled by a lender or a mortgage loan service provider.[3]

Pros and Cons of Escrow

The pros and cons of earnest money escrow for buyers and sellers are:

  • Pro: The buyer and seller have the assurance that the funds will be distributed according to the contract.
  • Con: There may be a small fee for the escrow service.

The pros and cons of mortgage escrow for homeowners are:

  • Pro: Responsibility for making tax and insurance payments on time falls to the escrow account manager. If a payment is late, the burden of any late fee or penalty rests with the escrow account manager.
  • Pro: By paying into the escrow account monthly, homeowners can be sure that the money will be available when the bills come due. This protects homeowners from the serious consequences of failing to make these critical payments, including a lapse in insurance coverage and potential tax foreclosure.[4]
  • Pro: Rather than receiving a bill every 6-12 months for your taxes and/or insurance premiums, these expenses are divided into monthly amounts that many homeowners find more manageable.
  • Pro: Some lenders may offer a slight mortgage rate reduction for borrowers who choose to use an escrow account.[5]
  • Con: Paying into escrow accounts monthly means that the homeowner is tying up funds before the bills are due. If estimates are higher than actual expenses, they will tie up more money than is strictly necessary. This can be a downside if the homeowner has more immediate plans for those funds.
  • Con: Homeowners might not shop for better deals on insurance or appeal their tax bills if a third party makes the payments on their behalf.
  • Con: Home buyers may need to pay more at closing to ensure that the mortgage escrow account has enough funds to cover the first tax bill and insurance premium.

The Bottom Line on Escrow Accounts

Escrow accounts can be a useful tool for safely holding and dispersing funds in accordance with a signed contract. 

Earnest money escrow accounts provide peace of mind to both buyers and sellers that the good-faith deposit is held securely and paid out to the appropriate party as instructed by the purchase contract. 

Mortgage escrow accounts protect homeowners by ensuring that funds are available for property taxes and insurance premiums when those bills come due. It also transfers the burden of remembering to pay the tax and insurance bills from the homeowner to the escrow account manager.

When paying into an escrow account, it is important to understand who you’re paying, what expenses the payment covers, and how those funds will be disbursed. 

Learn more with PNC Bank’s Escrow Guide or connect with a mortgage professional to discuss your options.