Escrow is one of those financial terms that often leaves homebuyers scratching their heads. Despite the confusion, it plays an essential role in both purchasing a home and managing it afterward. Understanding how escrow works can make the buying process smoother and help you avoid surprises once you become a homeowner.

The tricky part is that “escrow” can mean two very different things in real estate. During the home purchase, escrow refers to a short-term account that holds money—such as your earnest money deposit or closing funds—until the sale is finalized. After you close, escrow takes on a longer-term role as an account managed by your lender to cover ongoing costs like property taxes and homeowners insurance.

Knowing which type of escrow you’re dealing with is the first step. More importantly, understanding how each works can help you plan for upfront costs and budget effectively. 

What Is an Escrow Account?

When people talk about escrow, they’re often referring to different things depending on where you are in the homeownership journey. Here’s the breakdown.

1. Transactional Escrow (Homebuying Phase)

This is the temporary escrow account that comes into play while you’re buying a home. Once your offer is accepted and the purchase agreement is signed, the home is considered “in escrow.”

A neutral third party—often a title company or escrow agent—manages this account. Its primary purpose is to hold your earnest money deposit until all the sale conditions, such as the inspection and financing approval, are met. If the deal goes through, the money is released to the seller at closing.

2. Mortgage Escrow (Homeownership Phase)

After you purchase your home, your lender typically sets up a long-term escrow account, sometimes called an “impound account.” Each month, part of your mortgage payment is deposited into it. The lender then uses those funds to pay your property taxes and homeowners insurance when they’re due.

This arrangement takes ongoing expenses off your plate and ensures the lender’s investment is always protected.

Quick Comparison

	Transactional Escrow	Mortgage Escrow
Primary Purpose	Holds earnest money until closing	Pays property taxes and homeowners insurance
Duration	Temporary (30–60 days, on average)	Long-term (often the entire life of the loan)
Who Manages It?	Title company or escrow agent	Your mortgage lender or loan servicer

Pros and Cons of Escrow Accounts

Escrow accounts serve different purposes depending on whether you’re in the process of buying a home or already own one. Looking at the advantages and drawbacks in both stages can help you understand how escrow fits into your financial plan.

During the Home Purchase

Pros

• Simplifies Closing: At closing, escrow ensures property taxes and insurance premiums are collected upfront and distributed correctly.
• Protects Buyers and Sellers: Escrow guarantees funds are handled fairly until all contract terms are met.
• Builds Lender Confidence: By agreeing to escrow, you show the lender you’ll stay current on required expenses, which may improve your loan terms.

Cons

• Higher Cash to Close: You may need to deposit several months of taxes and insurance into escrow upfront, increasing your closing costs.
• Less Control: The lender, not you, manages when those funds are disbursed.
• Can Feel Complex: First-time buyers may find the idea of setting aside large sums into a third-party account confusing or overwhelming.

After You Own the Home

Pros

• Convenience: Bundles mortgage, taxes, and insurance into one predictable monthly payment.
• Budgeting Help: Converts large, annual bills into manageable monthly chunks.
• Timely Payments: Reduces the risk of late fees or lapses in coverage since the lender pays directly.
• Peace of Mind: Especially helpful for homeowners who prefer not to track multiple due dates.

Cons

• Higher Monthly Payment: Escrow adds taxes and insurance on top of principal and interest.
• Payment Changes: Increases in taxes or insurance raise your escrow contribution, which means your mortgage payment can fluctuate from year to year.
• No Interest Earned: Money in escrow doesn’t grow, and you can’t access it.
• Less Flexibility: Disciplined homeowners who could manage payments themselves lose the ability to time or structure payments differently.

For homebuyers, escrow is primarily about ensuring a smooth and fair transaction at closing. For homeowners, it becomes a tool for convenience and budgeting, though at the cost of flexibility. Deciding whether escrow is right for you depends on your financial discipline, comfort with managing large bills, and whether you prefer simplicity or control.

What Is Paid Through a Mortgage Escrow Account?

A mortgage escrow account is set up by your lender to make sure essential home-related bills are paid on time. These payments are tied directly to the security and value of your home, which is why lenders require them to be handled through escrow. By collecting these costs monthly as part of your mortgage payment, your lender reduces the risk of missed bills and helps you manage large annual or semi-annual expenses more easily.

Core Payments

The primary purpose of escrow is to cover the recurring costs that keep your home legally and financially secure.

Property Taxes

• What they are: Property taxes are assessed by your city, county, or school district. They help fund local services such as public schools, police, fire departments, and infrastructure.
• Why they matter: If taxes go unpaid, the government can place a lien on your property. In extreme cases, this could even lead to foreclosure. By routing these payments through escrow, lenders ensure the property remains free of tax-related legal complications.

Homeowners Insurance

• What it covers: This insurance protects against financial loss from events like fire, theft, storms, or vandalism. Coverage may also extend to liability if someone is injured on your property.
• Why it matters to lenders: Your home serves as collateral for your mortgage. If it were damaged or destroyed, insurance makes sure both you and the lender are financially protected. That’s why lenders nearly always require it to be paid through escrow.

Other Possible Payments

Depending on your loan type, down payment, or location, your escrow account may also be used to cover additional costs.

Private Mortgage Insurance (PMI)

• When it applies: PMI is required on conventional loans if your down payment is less than 20%.
• How it works: This insurance protects the lender if you stop making payments. It does not directly benefit the homeowner, but it enables borrowers to qualify for a mortgage with a smaller down payment.
• Why escrow handles it: PMI premiums are bundled into escrow to guarantee timely coverage until you build up enough equity to cancel it.

Flood Insurance

• When it’s needed: If your home is located in a designated flood zone, federal law requires flood insurance. Even if it’s not mandatory, some lenders may still request it in high-risk areas.
• How it’s paid: Like homeowners insurance, flood insurance premiums can be managed through escrow to ensure uninterrupted coverage.

What Escrow Doesn’t Cover

Not every housing expense goes through escrow. Homeowners should be prepared to pay some bills separately.

• Homeowners Association (HOA) Fees: If your home is in a community with an HOA, dues are paid directly to the association. They typically cannot be included in escrow.
• Supplemental or One-Time Property Tax Bills: Standard property taxes are escrowed, but supplemental assessments (such as for new construction or reassessments) may not be. These are usually billed directly to the homeowner.
• Utilities and Maintenance Costs: Everyday expenses like water, electricity, landscaping, or repairs remain your responsibility and are not managed through escrow.

Understanding what escrow pays for helps you plan your monthly budget and avoid surprises. While escrow simplifies the payment of major recurring expenses, it doesn’t eliminate the need to set aside money for other homeowner costs. Recognizing what is and isn’t covered ensures you don’t confuse escrow with a full-service household expense account.

How Your Lender Manages Escrow

The Real Estate Settlement Procedures Act (RESPA) sets the rules lenders must follow, giving borrowers both transparency and protection.

The way lenders manage escrow is designed to keep your homeownership expenses predictable and manageable. Understanding this process helps you anticipate adjustments and plan for changes in your monthly payment.

Annual Escrow Analysis

Once a year, your lender performs what’s called an escrow analysis.

• They review the actual payments made for property taxes, insurance, and other items.
• They project how much will be needed for the upcoming year.
• If payments for taxes or insurance have gone up or down, your monthly escrow contribution will be adjusted to reflect the new costs.

This annual check keeps your account balanced and ensures there is enough money to cover expenses when they come due.

Escrow Cushion

Lenders are allowed by RESPA to maintain a cushion in your escrow account.

• The cushion can be up to two months’ worth of escrow payments.
• It acts as a buffer in case your bills rise unexpectedly, such as a sudden increase in property taxes or insurance premiums.
  

This safeguard helps prevent shortages and reduces the chance that you’ll be caught off guard by rising costs.

If There’s a Shortage

Sometimes your escrow account may not have enough funds to cover expenses, often because taxes or insurance costs increased. When this happens, you have two options:

• Pay the shortage in a lump sum to bring the account current.
• Spread the shortage over 12 months, which increases your monthly mortgage payment until the balance is restored.

This flexibility allows homeowners to choose the repayment method that best fits their financial situation.

If There’s a Surplus

On the other hand, if too much money has been collected, the excess is considered a surplus. RESPA requires lenders to handle surpluses in a specific way:

• If the surplus is $50 or more, your lender must send you a refund check.
• If it is less than $50, the amount may be credited toward your escrow payments for the next year.

This ensures that escrow accounts do not become an interest-free savings account for the lender, keeping the process fair for borrowers.

FAQs

Can I remove an escrow account?

In many cases, yes, but it depends on your lender and the type of loan you have. Some lenders allow borrowers to cancel escrow once they have built up enough equity, often 20% or more, and have a strong payment history. Others may require escrow for the life of the loan, especially if you made a small down payment or if state law mandates it. If you’re interested in removing escrow, you’ll need to request it from your lender, who may charge a small fee for the change.

What happens if I pay off my mortgage?

When your mortgage is fully paid, your lender no longer needs to collect money for taxes or insurance. Any remaining funds in your escrow account will be refunded to you, typically within 30 days of your final payment. From that point on, you’ll be responsible for paying property taxes and insurance premiums directly.

Do all lenders require escrow?

Not always. Escrow accounts are mandatory for certain loans, such as FHA and USDA mortgages, and for conventional loans where the borrower makes a down payment of less than 20%. Some lenders may also require escrow if your credit profile or financial history suggests a higher risk. If you put down a large down payment, have strong credit, and meet your lender’s requirements, you may be allowed to waive escrow and handle taxes and insurance yourself.