How Escrow Accounts Work

What is an escrow account?  Wikipedia defines it this way:

Escrow generally refers to money held by a third-party on behalf of transacting parties. It is best known in the United States in the context of real estate (specifically in mortgages where the mortgage company establishes an escrow account to pay property tax and insurance during the term of the mortgage).

So, how does it work?  When a home purchase closing commences, the settlement agent or title agent will review the closing disclosure with the home buyer.  On the closing disclosure will be a detailed review of the funds being collected for “prepaid items” and a detailed view of “initial escrow funds paid at closing.”  The difference is prepaids are funds the title agent will disburse to third parties after closing and escrow funds start your escrow account.  Prepaids include interest for the remainder of the month, the first year of home insurance premiums (due upfront), and any property taxes being paid out to the county at time of close.

Your home insurance agent will want the first year premium at time of close.  You will bring this along with your other funds needed at closing, and then the title agent will pay your insurance from those funds.  It is also an option to pay the first year insurance premium before closing and then provide the lender/creditor with the paid in full insurance binder.

What is an aggregate adjustment?

Another line on the closing disclosure is “aggregate adjustment” which is a deduction from the total initial escrow account.  The initial escrow funds calculation for property taxes and insurance are done on a set number of months, depending upon a few criteria:

  • The month in which the loan is funding
  • The first payment date
  • When property taxes and insurance are next due

The calculation is done to keep the escrow account above $0 for the entire next year, but as close to $0 as possible.  Rules govern the amount of funds a creditor can hold in escrow, thus the aggregate adjustment is a line that balances out the account to bring the initial balance to just the right amount with a small amount of extra reserve.

With an established initial escrow account and  adding to it each month as part of mortgage payments, future taxes and insurance will be paid.  The title agent will put enough in there so it has just enough to pay the future property taxes and insurance premiums.  Typically one of the closing documents will be the escrow account agreement, and shows the monthly amount being collected and future disbursements.  It is still the home owner’s ultimate responsibility to insure the account has enough funds.  If property taxes or insurance increase, the annual escrow review from the loan servicer will have options to pay the shortfall in a lump sum or add it to future payments.  Then, of course, the monthly escrow payment will also increase to cover the future property taxes and insurance.

Benefit of escrowing property taxes and insurance:

Escrow accounts offer convenience and peace of mind.  In Minnesota, counties collect property taxes twice per year in May and October.  These are easy to miss if paid outside of an escrow account and then penalties get assessed.