Individuals new to the home buying marketplace may be introduced for the first time to the concept of escrow. In fact, when buying a new home, the money placed in an escrow account is oftentimes the largest expense associated with a home's closing cost.
In this article, we're going to provide a thorough explanation of escrow, including a brief definition and the purpose of these accounts. Then we'll finish up with some examples, including a link to an online escrow calculator.
What is Escrow?
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While most people associate escrow with the purchase of a home, it's better to define it more broadly as a legal agreement that involves the deposit or delivery of an asset, which is usually money, to a third party. That third party is known as an escrow agent. The agent is then responsible for carrying out the instructions agreed to between two or more parties.
The money held by the escrow agent is usually kept in a trust until certain conditions are met. Once those conditions are satisfied, the agent will deliver the asset to its rightful owner. Until then, the agent is bound by their fiduciary responsibilities to keep and maintain the escrow account.
Real Estate / Mortgage Escrow
When closing on a home, the lender, bank or mortgage company will usually require the buyer to establish an escrow account. The money deposited into this account is then used to pay for expenses such as real estate / property taxes, homeowners insurance, and even flood insurance (if required).
The escrow protects the lender by ensuring sufficient funds always exist to pay both the taxes and insurance premiums in a timely fashion. It serves to protect the investment the mortgage company has in a home until the loan is satisfied.
Money Due at Closing
An escrow account is usually established at a home's closing. This is where the initial deposit into the account frequently takes place. Later on, we'll examine the calculations used to figure out exactly how much money is needed to satisfy this initial deposit.
Monthly Escrow Payments
Each month, lenders require borrowers to make subsequent payments into their escrow account. This money is usually added directly to, and collected along with, the monthly mortgage payment. In other words, the total funds collected will be the sum of principal and interest owed on the loan, property taxes, insurance and private mortgage insurance / PMI (if needed).
The escrow agent will hold and collect money each month, but they're also responsible for making payments from the account. The agent will send real estate / property tax payments directly to the government agency responsible for collecting such taxes. The agent will also make payments on a homeowners insurance policy as the premiums come due.
Escrow Calculations
Many times, lenders will structure escrow accounts with a built-in cushion. If the borrower is late with a payment, the lender can still pay the taxes or insurance on time. That being said, the Real Estate Settlement Procedures Act (RESPA) limits the amount of money the lender may require for the payment of taxes and / or insurance.
RESPA limits lenders to a cushion equal to one-sixth of the total expenses paid from the escrow account, which from a practical standpoint is equal to two monthly payments. Some states or lenders may allow for a lesser amount, but the cushion limit, or maximum, is two months of payments.
The initial and monthly escrow payment calculation only requires four pieces of data:
Annual Property / Real Estate Taxes
Annual Flood Insurance Premiums
Homeowners Insurance Premiums
Number of Months Before the First Payment
The first three values are used to calculate the total amount of expenses paid from the escrow account each year. The final input, the number of months before the first payment, is used to calculate the starting balance.
Example Calculations
In this example, property taxes are $5,000 per year, flood insurance is $300 per year, and the homeowner's insurance premium is $1,200. The first quarterly tax payment is due in just one month. This means that a total of $6,500 in expenses is paid from the escrow account each year.
From the above information, we know the starting escrow balance needs to be $1,791.67, and the monthly payments are $541.67. The minimum balance is equal to twice the monthly payment, or $1,083.33.
The payment pattern into and from the escrow account, along with the balance, appear on the following table:
Escrow Example Table
Month | Payment | Balance | Expense |
Start | $1,791.67 | ||
1 | $541.67 | $1,083.34 | $1,250.00 |
2 | $541.67 | $1,625.01 | |
3 | $541.67 | $2,166.68 | |
4 | $541.67 | $1,458.35 | $1,250.00 |
5 | $541.67 | $2,000.02 | |
6 | $541.67 | $2,541.69 | |
7 | $541.67 | $1,833.36 | $1,250.00 |
8 | $541.67 | $2,375.03 | |
9 | $541.67 | $2,916.70 | |
10 | $541.67 | $2,208.37 | $1,250.00 |
11 | $541.67 | $2,750.04 | |
12 | $541.67 | $1,291.71 | $2,000.00 |
Online Escrow Calculator
Readers that are interested in running through some additional examples can use our online escrow calculator. This tool allows users to run through numerous examples. As illustrated in the above table, the calculator can determine the monthly payment, minimum, starting, and even a theoretical maximum account balance.
As is the case with all of the online tools published on this website, the escrow calculator comes complete with instructions as well as information on how to interpret the results.
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