What Is an Escrow Account? How Mortgage Escrow Works

If you have a mortgage, there is a good chance part of your monthly payment goes into an escrow account. So what is an escrow account? It is an account your mortgage servicer manages to collect money for your property taxes and homeowners insurance, and then pay those bills for you when they are due.

This guide explains how mortgage escrow works, how the monthly amount is calculated, what the "cushion" is, and why escrow payments can go up or down each year. It is general education, not legal or financial advice. Your loan documents and your servicer are the final word on your account.

Two meanings of "escrow"

The word escrow is used in two different ways in real estate:

1. Escrow during a home purchase. A neutral third party holds money, such as your earnest money deposit, until the sale closes.
2. A mortgage escrow account. After closing, your servicer collects money every month to pay recurring property bills.

This article is about the second meaning: the ongoing escrow account attached to your mortgage.

What an escrow account pays

A mortgage escrow account usually covers:

• Property taxes charged by your county or city.
• Homeowners insurance premiums.
• Mortgage insurance, such as PMI or FHA mortgage insurance, in some loans.
• Flood insurance, if required for the property.

It usually does not cover HOA dues, utilities, or home repairs. Those you pay yourself.

Together with principal and interest, these costs make up PITI: principal, interest, taxes and insurance. Our what is PITI guide explains each part.

How an escrow account works, step by step

1. At closing, you typically fund the account with an initial deposit. This makes sure there is enough money for the first bills. It shows up in your closing costs as prepaid items and initial escrow deposits.
2. Every month, part of your mortgage payment goes into the escrow account.
3. When bills are due, the servicer pays your property tax and insurance directly from the account.
4. Once a year, the servicer reviews the account, recalculates the monthly amount and sends you an escrow statement.

How the monthly escrow amount is calculated

The basic idea is simple: take your expected yearly bills and divide by 12.

Monthly escrow = (annual property tax + annual insurance + other escrowed items) ÷ 12

Example with round, made-up numbers:

So in this example, $450 per month is added to your principal and interest payment. To see this combined payment, try our mortgage calculator with taxes and insurance.

What the escrow cushion is

Servicers are allowed to keep a little extra in the account as a safety buffer, called a cushion. Under the federal rule that governs escrow accounts, Regulation X (12 CFR 1024.17), the cushion can be no more than one-sixth of the estimated total annual payments from the account. That is roughly two months of escrow.

Using the example above, one-sixth of $5,400 is $900. A servicer could keep up to that much as a cushion at the low point of the year. Your loan documents or state law may set a lower limit.

The cushion helps cover small increases in bills during the year, so the account does not run short.

The annual escrow analysis

Once a year, your servicer performs an escrow analysis. It compares what was paid in and out during the past year with what it expects to pay next year. Under Regulation X, the servicer must send you an annual escrow statement within 30 days of the end of the escrow computation year.

The analysis can produce three results:

• Balanced: the account is on track. Your escrow payment may still change if bills are expected to change.
• Shortage or deficiency: the account has less money than needed.
• Surplus: the account has more money than needed.

Why escrow payments go up

Escrow increases are one of the most common reasons a monthly mortgage payment rises, even on a fixed-rate loan. Common causes:

• Higher property taxes after a reassessment or new tax rates. See how property taxes affect mortgage payments and our property tax guide.
• Higher insurance premiums at renewal.
• A shortage from last year that needs to be repaid.
• A tax exemption that ended, such as a new-construction lot assessment changing to a full home assessment.

An increase usually has two parts: the higher ongoing cost, plus a repayment of any shortage.

Escrow shortage vs surplus

Shortage. If the account is projected to fall below the required level, you have a shortage. Servicers commonly let you pay it all at once or spread it over the next 12 monthly payments. Rules on the options depend on the size of the shortage and your loan.

Surplus. If the account has more than it needs, you have a surplus. Under Regulation X, if the surplus is $50 or more and you are current on your payments, the servicer must refund it within 30 days of the analysis. A surplus under $50 may be refunded or credited toward next year's escrow.

A worked shortage example

Here is how a typical shortage plays out, again with made-up round numbers.

Last year, your property tax was $3,600 and your insurance was $1,800, so you paid $450 a month into escrow. This year, the county reassessed your home and the tax bill rose to $4,200, while your insurance renewed at $2,040. The new yearly total is $6,240.

Because the higher bills were paid out of an account funded at the old rate, the account ended the year lower than planned. Suppose the analysis finds a shortage of $600. If you spread it over 12 months, that adds $50 a month, so your new escrow payment would be about $570, or $120 more than last year. If you pay the $600 at once, your new escrow payment would be about $520.

This is why homeowners on fixed-rate loans can still see their payment rise. Principal and interest did not change at all; only the escrow portion did. Run your own version of this with the amortization schedule and the taxes-and-insurance calculator to see the combined effect.

Is an escrow account required?

It depends on the loan. Many lenders require escrow, particularly when the down payment is small. Government-backed loans commonly require escrow too. Some conventional borrowers with larger down payments may be allowed to waive escrow and pay taxes and insurance themselves, sometimes for a fee or a slightly different rate. Ask your lender what applies to your loan.

Pros of escrow

• Bills are paid on time automatically.
• Large yearly bills are spread into monthly amounts.
• Less risk of missing a tax deadline.

Cons of escrow

• Your monthly payment is higher.
• The cushion ties up some of your money.
• Payment changes can be surprising after the annual analysis.

How to read your escrow statement

Your annual statement usually shows:

• Payments into the account last year.
• Disbursements for taxes and insurance, with dates.
• The projected balance month by month for next year.
• The lowest projected balance compared with the allowed cushion.
• Your new monthly escrow payment and any shortage or surplus.

If a number looks wrong, such as a tax bill paid twice or an insurance premium that does not match your policy, contact your servicer in writing. Keep copies of your tax bills and insurance declarations so you can compare.

Tips to avoid escrow surprises

• Watch your property tax notices. If your assessed value rises, expect a higher escrow payment next year.
• Shop insurance at renewal. Changes in your premium flow straight into escrow, so tell your servicer if you switch insurers.
• Budget for a change each year. Even on a fixed-rate loan, the total payment can move.
• Check exemptions. Homestead or other exemptions you qualify for can lower your tax bill. Rules vary by state and county.
• Use the calculator. Test different tax and insurance amounts on our mortgage calculator to see how your payment would change.

Escrow and PMI

If your loan has private mortgage insurance, it is often collected along with escrow in your monthly payment. When PMI is removed, your monthly payment goes down. See when can I cancel PMI and what is PMI to learn more.