Escrow refers to money or documents held in trust by an impartial third party. Many real estate deals utilize two types of escrow accounts, also known as reserve or impound accounts. The first is a temporary account that holds a good faith deposit in reserve until the closing day. The second type is a permanent account set up to hold funds for expenses like property tax and homeowners insurance payments.
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How It Works
When a permanent escrow account is required, it's generally because your mortgage payment also includes funds earmarked for property taxes and homeowner's insurance. Each month, part of your mortgage payment goes into the escrow account. When tax and insurance premiums come due, the account administrator pays the bills from the accrued balance. You’ll receive an escrow balance refund or account credit if there’s money left over, or a bill for the balance if there’s a shortage.
Minimum Balance Requirements
The federal Truth in Lending Act specifies when and for how long a lender must establish a permanent escrow account, and Section 10 of the Real Estate Settlement Procedures Act covers escrow balance requirements.
Balance discrepancies often occur because property tax and insurance payments are based on estimates for the coming year. To prevent shortages that may result from inaccurate estimates, RESPA laws allow -- but do not require -- escrow account administrators to establish a minimum balance rule. Unless state laws differ, a cushion of one-sixth of the total annual bills for all escrow
payments is the maximum allowed. According to the U.S. Department of Housing and Urban Development, this usually equates to about two months of escrow payments.
Escrow Payment Calculations
If your estimated annual property tax and homeowner’s insurance bills are $5,000 and $900, respectively, the monthly escrow payment for these is $5900/12 or $491.67. To prevent against a possible shortage, the account may have a two-month minimum balance requirement of $983.34. In the first year of the mortgage, your monthly escrow payment would increase by $81.95 to a total of $573.62 to establish the cushion.
Once each year, the account administrator will conduct an escrow account analysis and send you a disclosure statement that sets the monthly payment for the coming year. Whether your escrow payment increases or decreases depends on the lowest projected balance in the account at year’s end and on estimates for the coming year.
For example, if the actual property tax bill is $5,250 instead of the estimated $5,000, the excess will come out of the $983.34 cushion, leaving you with a balance of $733.34. If property taxes and homeowner’s insurance estimates for the coming year are $5,250 and $900 respectively, your monthly escrow payment for these will increase to $512.50. The minimum balance requirement increases to $1025, but since there is already a cushion of $733.34, you’ll only need to add another $291.66 -- or $24.31 per month -- over the coming year. Therefore, your monthly escrow payment actually decreases from $573.62 to $536.81 for the next 12 months.