If you've ever made an informal bet with a friend, you may have asked a third person to hold the money until the wager was resolved. When you take out a mortgage to buy a home, you're doing something simiar by opening an esrow account.
How it works
When you put money in escrow it is held by a neutral thrid party (called an escrow agent) who works for both the lender and the borrower. The agent's role is to carry out the instructions agreed upon by both sides. The money is released when all the terms of the agreement are met. Escrow can be involved in anything from multimillion-dollar building projects to purchases made on online sites.
When it's used
When your mortgage closes, your lender will usually require you to open an escrow account to cover property taxes and homeowner's insurance. You'll make an initial deposit, followed by payments to the account every month. (Usually these are added to you regular mortgage payment.) The escrow agent will then release these funds as your taxes and insurance premiums come due.
Its purpose
The idea is to protect the lender by ensuring that you pay your taxes and insurance on time. If you default on your property tax, for example, your municipality can put a lien on the house, which would make it difficult to sell. Or if your house burns down and you've negected to pay the insurance, the lender would be left with no collateral.
How you benefit
Escrow can benefit borrowers by helping them spread insurance and tax expenses evenly over 12 payments. For example, assume your yearly property taxes or two payments of $1,000 each, and your insurance is $400 annually. If you pay these directly, it would mean three large payments a year; your escrow costs, however, would be a manageable $200 a month.
Escrow payments
Your escrow account will have a built-in cushion--if you miss a payment, the lender must still be able to pay your account on time. However, federal law prohibits lenders requiring more than two months. And because your tax and insurance cost will change slightly from year to year, the lender will review and adjust your escrow payments annually.
When escrow may be waived
In most states, the money you place in escrow accounts earn no interest for you. For that reason, many borrowers prefer to pay their taxes and insurance directly. Lenders may agree to this if your down payment is more than 20 percent, although some may raise your interest rate slightly to compensate. Once you agree to putting funds into an escrow account, however, it is difficult to cancel it, so make sure you fully understand the arrangment before your mortgage closes.
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