Buying a home comes with many new terms, and one you may have heard is “escrow.” It might sound complex, but understanding escrow can actually make managing your home loan easier and give you peace of mind throughout the process.

What Is Escrow in a Home Loan?

Escrow is a financial arrangement designed to keep home purchases and mortgage payments organized and secure. It serves two main purposes:

• Holding funds related to your home purchase until the deal is complete.
• Managing property tax and homeowners insurance payments after you move in.

Escrow protects both buyers and lenders. For buyers, it ensures their deposit is secure until the home sale is finalized. For lenders, it guarantees that essential expenses like taxes and insurance are paid on time.

Escrow During the Home-Buying Process

When you make an offer on a house, you typically include a “good faith deposit,” also called earnest money. This deposit shows the seller you’re serious about purchasing the home. Instead of giving this money directly to the seller, it’s placed in an escrow account managed by a neutral third party, like an escrow company or attorney. This ensures the funds are only released when both parties meet the contract’s conditions.

If the sale goes through, your deposit is applied to your down payment or closing costs. If the deal falls through due to reasons outlined in the contract—like a failed inspection—you typically get your deposit back. However, if you back out without a valid reason, the seller may keep the deposit.

Escrow Accounts for Taxes and Insurance

Once you close on your home, escrow becomes part of your monthly mortgage routine. Your mortgage payment typically includes:

• Principal: The amount you borrowed.
• Interest: The cost of borrowing money.
• Escrow: Funds set aside for property taxes and homeowners insurance.

Your lender holds the escrow portion in a separate account and pays your taxes and insurance when they’re due. This setup prevents you from needing to pay large lump sums and helps you avoid missing important payments.

How Are Escrow Payments Calculated?

Your lender estimates your annual property tax and homeowners insurance costs and divides that total by 12 to calculate your monthly escrow payment. To avoid shortages, lenders usually add a cushion—typically a couple of months’ worth of payments—to cover unexpected increases in taxes or premiums.

For example, if your annual property taxes are $4,800 and your homeowners insurance is $1,200, your lender will divide the $6,000 total by 12, resulting in a $500 monthly escrow payment. This amount is added to your mortgage principal and interest payment.

Changes in Escrow Balances

Your escrow balance can change if your property taxes or insurance premiums increase. Your lender reviews your escrow account annually and adjusts your payment if necessary. If there’s a shortage, you may need to pay the difference in a lump sum or spread it over future payments. If there’s a surplus, your lender may issue a refund or apply it to future payments.

Benefits of an Escrow Account

• Simplified Budgeting: Escrow spreads large expenses over 12 months, making it easier to manage your monthly budget.
• On-Time Payments: Your lender ensures taxes and insurance are paid on time, helping you avoid penalties or lapses in coverage.
• Increased Security: Escrow protects your home by ensuring property taxes and insurance are consistently paid, preventing liens or uncovered damages.

Potential Drawbacks of Escrow

• Higher Monthly Payments: Your mortgage payment will be higher because it includes escrow, but this means you’re staying ahead on taxes and insurance.
• Payment Adjustments: Annual escrow reviews can lead to changes in your monthly payment if your taxes or insurance costs increase.
• Limited Coverage: Escrow only covers property taxes and homeowners insurance—you’ll still need to budget for utility bills, HOA fees, and other costs.

Your Friends in Banking Are Here to Help

At The Harvard State Bank, we’re committed to making your home loan experience as smooth as possible. If you have questions about escrow or any other part of the mortgage process, our friendly mortgage team is here to guide you. Call us at 815-943-4400 or visit one of our local branches—we’re Your Friends in Banking!