If you’re a first-time home buyer, there are many new terms to learn. You’ve probably heard of escrow accounts and are wondering what exactly home escrow even is. In this article we’ll break down exactly what escrow is, and we’ll focus on the most important parts that homebuyers need to know. So what is home escrow? Let’s take a look!
What Does Home Escrow Mean?
There are two different functions when it comes to home escrow. First, escrow is the time period between when a seller accepts an offer on a house and when the buyer takes ownership of it. It’s that waiting period that happens while both parties wait on the home inspection and appraisal to be done, the title work to happen, and any other legal requirements that may be involved in the home sale.
During this time period, if you’re the buyer, you’ll likely put down what’s called earnest money. Earnest money is essentially a good faith deposit – that you’re serious about purchasing the home and you’ll follow through with the contract. If all goes well and the home purchase is completed, that earnest money gets applied to your down payment. That earnest money deposit is held in an escrow account by the title company until the home purchase is complete.
The second aspect of home escrow is the escrow mortgage account. This is an account your mortgage lender establishes to hold part of your mortgage payments each month to pay for certain home expenses each year. We’ll look at that more closely in the next section.
What is the Home Escrow Account Used for?
A home escrow account is essentially a savings account for two big annual home expenses: your homeowner’s insurance premium and your property taxes. Your lender establishes this behind-the-scenes, and you aren’t able to access the funds if necessary like a typical savings account. Its sole purpose is to make sure those property expenses get paid, protecting both you and your lender. To make sure there’s enough money in the account to pay those expenses, your lender will typically require an excess amount equal to about two month’s worth of payments to stay in the escrow account.
Your home escrow account will get analyzed every year to make sure enough money is held back each month to pay for insurance and taxes. Insurance premiums and property taxes fluctuate based on current property values and other factors. This means your mortgage payment may (and likely will) change from year-to-year.
If there is a large amount left in your escrow account after insurance and taxes are paid, you’ll likely receive a refund from your lender and have your monthly mortgage payment lowered so there is not as large of a surplus next year. If there was not enough in the escrow account to cover those insurance and tax payments, however, you are usually given the option to make a one-time lump sum payment to cover the balance, or have your monthly mortgage payment increased to cover it over time.
Is the Home Escrow Account Required?
It depends on the terms of your mortgage. With a conventional mortgage, you’ll likely have to have a 20% down payment to opt-out of an escrow account. If you’re a first-time homebuyer with an FHA loan, you’re required to have an escrow account. With some mortgages, you may be able to stop paying into an escrow account when your loan-to-value ratio hits a certain threshold. If you’re interested in opting-out of your escrow account, talk with your mortgage lender/loan servicer to see what your options are.
You may be wondering why lenders care so much about escrow accounts. Basically, it protects their interest in your home if a worst case scenario were to happen. By requiring you to pay into an escrow account, your mortgage provider knows that the tax bill and insurance premiums will get paid every year. If a catastrophe happens to your home, your lender knows your homeowners insurance is covered and active. They know the property taxes will get paid every year, so the tax authority could not attempt to foreclose on the home due to non-payment. Escrow accounts protect you and your lender in situations like these.
Benefits of a Home Escrow Account
You may be wondering, why even have an escrow account? After all, you handle all your other bills personally. What makes an escrow account different?
Like we mentioned earlier, an escrow account protects both you and your mortgage provider. A huge benefit of an escrow account for you is peace of mind. You don’t have to worry if you’ve set enough money aside to pay for your property taxes and homeowners insurance – it’s already done. Many personal finance experts are proponents of automation. When you can “set and forget” something, the less you have to think about it, and the more likely it is to get done. You’ll also save time by not having to go online or in person to make the payments to the tax office and insurance company yourself.
Keep in mind that escrow accounts don’t cover every cost associated with homeownership. You’ll need to set money aside to pay for HOA fees (if applicable) and home maintenance and repairs as they come up. For more on home expenses and savings, read How Much Money Should I Save Before Buying a House?
Drawbacks of a Home Escrow Account
If you’re someone who enjoys a more “hands on” approach to your finances, you may consider an escrow account to be a drawback. You may prefer to save the money (and pay the bills) yourself instead of relying on your bank to do it for you.
Escrow calculations are not an exact science, so you may find yourself owing money towards an escrow shortage at the end of the year after expenses are paid. It could go the other way and you end up with an escrow surplus also, but you always have to be prepared that you might owe more money at the end of the year.
You also lose out on the small amount of interest you could earn by placing your taxes and insurance savings into your own savings account. However, as of January 2022, the current national average APY for a savings account is only 0.06%. Certificates of Deposit (CDs) aren’t much better, with a 12 month CD averaging 0.13% APY. That’s an average yearly interest earnings of $3 and $6.50 on an example $5,000 balance, respectively. Interest rates are frequently changing, and as rates increase, these potential missed earnings increase as well.
Buying a house is a big learning process, especially if it’s your first time. You’ll hear lots of new terms like home escrow, and we hope this article has helped to break it down into an easy-to-understand concept. If you’re a first-time homebuyer, be sure to read The Home Buying Process: What to Expect When Buying a House to learn more about what you can expect, from research, to putting in an offer, to closing day.
If you’re looking to buy a home in the Roseville, Granite Bay, Rocklin, or greater Sacramento area, let our team at Quantum Real Estate help. Our team of real estate professionals have been serving the area for 28+ years combined, and we would love to get you in the home of your dreams! Just click here to contact us – we can’t wait to get to know you.