Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Escrow Account

What it is:

In the real estate world, mortgage companies use escrow accounts to collect property taxes, homeowners insurance, private mortgage insurance and other payments that are required by the homeowner but are not part of principal and interest. Escrow accounts are also called impound accounts.

How it works (Example):

Let's say John Doe buys a house and borrows $100,000. The interest rate is 4%, and the loan is a 30-year mortgage. His monthly payment is $477.42, which includes interest and principal.

John Doe didn't put down 20%, so the lender requires an escrow account. Every month, another $250 is deducted automatically from John's checking account and put in the escrow account. This ensures that the money is there to pay the insurance and property tax bills when they arrive every six months.

Why it Matters:

Escrow accounts mitigate a lender's risk because they ensure that the homeowner won't lose the house (which is the bank's collateral for the mortgage) due to tax liens or unpaid insurance bills. Usually, the mortgage lender is responsible for paying the tax and insurance bills out of the escrow account on time; however, if the mortgage lender fails to do so, the homeowner is still on the hook.

Usually, lenders require escrow accounts when the borrower puts down less than 20% on a house. If the borrower puts down more than 20%, escrow accounts aren't always required, though they are often convenient for ensuring that the bills are paid.