When you buy a home using a mortgage, you are likely to run into the term “escrow.”

The idea behind escrow is to make sure that large transactions go through. The introduction of a third-party into the transaction can help ensure that all points of the transaction are covered and that all parties involved do what they are supposed to do.

How Escrow Works

With this type of arrangement, a trusted third-party manages the funds. For most people, escrow is something that happens when a home is bought, although it can be used for other large transactions that take place between two parties that might not be able to completely trust each other.

With a home purchase, escrow works as follows:

  • After the buyer arranges financing with the lender, the lender puts the funds into an escrow account.
  • The seller can see that the funds are in the escrow account, so it is clear that they are available.
  • The funds remain in the escrow account until all the papers are signed and property deed is properly issued to the buyer.
  • Once the documents are cleared, the third-party releases the money in escrow to the seller.

This process protects everyone involved. The seller doesn’t sign over his or her property until it is clear that the funds are available. The buyer doesn’t lose his or her money on a crooked deal because the funds aren’t turned over until all the paperwork is in order.

Managing Property Taxes and Insurance through Escrow

While escrow is used to complete large transactions, it can also be useful in handling property taxes and insurance on a property. With this type of escrow account, the lender is usually the instigator.

Lenders want to make sure that you are paying your insurance premiums and your property taxes. Remember: When you borrow to buy a home, it’s actually the lender’s money on the line. If you are delinquent on your property taxes or if your home is seriously damaged and you don’t have insurance, there is a chance that you will skip out — and the lender is left with the losses.

In order to make sure that your taxes and insurance are paid, the mortgage lender often collects your insurance premium money and property tax money at the time you make your mortgage payment. The money meant for property taxes and insurance goes into an escrow account, and the rest goes toward your mortgage balance.

Usually, insurance premiums are paid twice a year, so the escrow agent makes the appropriate payment at the proper time. Property taxes are often made once a year, so the money piles up in the escrow account, and the agent makes the payment at the right time.

If things chance, that is reflected in the escrow account. If property taxes rise, you receive a bill for the difference, and your monthly payment might rise. On the other hand, if your taxes drop, you will receive a check for what’s left in the account.

While it’s possible to avoid escrow and handle insurance and property tax payments on your own, most lenders won’t let you do so unless you have a 20% down payment. And, if you have a government-backed loan (USDA, FHA, VA), there is now way to get out of using escrow.

Before you close on a home, make sure you understand how escrow works, as well as your monthly obligation to pay into the escrow account.