Mortgage Escrow Accounts Explained: Taxes, Insurance and Monthly Payments

When you're planning your home purchase budget, you'll want to account for more than just your mortgage principal and interest. That's because your monthly payment will likely include an escrow account — a dedicated fund that covers your property taxes and homeowners insurance.

If you've heard the term "escrow" during the homebuying process, you may be wondering how it differs from the escrow used when closing on a home. A mortgage escrow account (sometimes called an impound account) serves a different purpose: It's a financial tool that helps you budget for large annual expenses by spreading them across 12 manageable monthly payments.

What Is a Mortgage Escrow Account?

A mortgage escrow account is a financial account managed by your lender or loan servicer. Each month, you deposit a portion of your property taxes, homeowners insurance and mortgage insurance (if applicable) into this account. Your lender then uses these funds to pay your tax and insurance bills on your behalf when they come due.

Here's how it works: If your annual property taxes and insurance premiums total $6,000, you'll pay approximately $500 per month into your escrow account. Your lender holds these funds and makes the payments directly to your local tax authority and insurance company.

A mortgage escrow account makes budgeting easier by breaking larger annual or semi-annual bills into smaller, predictable monthly payments.

What Does an Escrow Account Pay For?

Your escrow account typically covers three main expenses:

• Property taxes: Your lender pays your property tax bills to your local municipality on your behalf
• Homeowners insurance: Annual or semi-annual insurance premiums are paid directly to your insurance provider
• Mortgage insurance: If applicable, private mortgage insurance (PMI) or FHA mortgage insurance premiums are paid from your escrow account

Keep in mind that escrow accounts generally don't cover supplemental tax bills, homeowners association (HOA) fees or utilities. You'll need to budget for these expenses separately.

How Escrow Affects Your Monthly Mortgage Payment

When you have an escrow account, your total monthly mortgage payment includes four components, often abbreviated as PITI (Principal, Interest, Taxes and Insurance):

• Principal: The amount that pays down your loan balance
• Interest: The cost of borrowing money
• Taxes: Property tax payments
• Insurance: Homeowners and mortgage insurance premiums

Let's look at an example.

If your total monthly mortgage payment is $2,000, here is how it could be broken down:

• Principal: $800
• Interest: $600
• Taxes: $400 (This portion goes into your escrow account)
• Insurance: $200 (This also goes into your escrow account)

In this scenario, $1,400 of your payment goes toward principal and interest, while the remaining $600 is held in escrow to cover your property taxes and homeowners insurance.

Because property taxes and insurance costs can change annually, your monthly payment may also change, even if your principal and interest remain the same. Tax rates may increase, or your insurance premium may rise after a claim. When this happens, your lender will adjust your escrow payment accordingly.

How Escrow Is Calculated and Adjusted

Your lender establishes your escrow account at closing. You'll make an initial deposit that includes a portion of your first year's insurance and up to two months of property tax payments. Under guidelines from the U.S. Department of Housing and Urban Development (HUD), your lender can hold a maximum of two months of payments as a cushion.

After closing, you'll make monthly escrow deposits along with your regular mortgage payment. Your lender analyzes your escrow account annually to verify they're collecting the right amount for anticipated expenses.

What Happens If Your Escrow Account Has a Shortage or Surplus?

Your lender will conduct an annual review to compare the funds collected with the actual tax and insurance bills paid. Here's what you might expect if your account shows a shortage or surplus.

Managing a Shortage

Your escrow account may not have enough funds if your property taxes or insurance premiums increase. Common reasons include:

• Property tax increases from reassessments or annual rate adjustments
• Higher insurance premiums due to claims, market changes or updated coverage
• Changes in local tax rates or levies
• Adjustments to payment schedules that require earlier or larger disbursements

If your account shows a shortage, you have two options:

• Pay the full shortage amount. This one-time payment eliminates the current deficit but may not prevent future payment increases.
• Spread the shortage over 12 months. Your monthly payment will increase to cover both the shortage and anticipated future expenses.

Paying in full won't necessarily prevent your payment from increasing if your lender anticipates higher bills ahead. Consider setting aside an extra 15% to 20% of your annual escrow costs as a cushion against potential increases.

Receiving a Surplus Refund

If your escrow account has more than the minimum required balance, you're entitled to a refund. Lenders typically refund any surplus over $50. If the surplus is less than $50, your lender will typically credit the amount toward your future payments.

Do All Mortgages Require an Escrow Account?

Escrow requirements depend on your loan type and down payment amount:

When Escrow Is Required:

• FHA loans always require an escrow account.
• Conventional loans require escrow if you put down less than 20% (10% in California).
• While the VA does not require escrow accounts for VA mortgages, it does require that property taxes are paid and hazard insurance remains in place. As a result, most lenders, including Pennymac, require escrow accounts for taxes and insurance on VA loans if the LTV at closing is above 80% to ensure compliance.

Can You Remove or Opt Out of Escrow?

If you meet certain qualifications, you may be able to remove escrow from your mortgage. This is typically available for conventional loans once you've built at least 20% equity and have made timely payments for at least one year.

Why You Might Still Choose An Escrow Account

Even if your lender allows you to waive escrow, consider requesting one voluntarily for budgeting purposes. Without an escrow account, you take full responsibility for making timely property tax and insurance payments. Be sure you're comfortable managing these costs and staying current on payments, since missed property taxes or insurance premiums can lead to penalties, tax liens or other consequences. Many lenders also charge a fee for waiving escrow.

Pros and Cons of Having an Escrow Account

An escrow account can simplify your finances, but it's important to understand both the advantages and disadvantages.

Advantages

Easier budgeting: Spreading large expenses across 12 months makes budget management easier. You'll avoid having to scramble for lump-sum payments.

Automatic payment: Your lender handles all tax and insurance payments on time, so you don't have to track due dates or risk late fees.

Protection: Lenders cover any shortfalls if your escrow account runs low, though you'll need to reimburse the difference.

Disadvantages

Higher monthly payments: Adding escrow to your mortgage payment increases your month-to-month housing costs.

Payment fluctuations: Annual changes to property taxes and insurance premiums can cause your monthly payment to increase, sometimes significantly.

Lower control: Some homeowners prefer managing their own payments and investing the funds in interest-bearing accounts until bills are due.

Tips for Managing and Monitoring Your Escrow Account

Stay proactive about your escrow account to avoid surprises:

Review your annual statement. Your lender provides a yearly escrow statement showing all transactions, payments made, and any adjustments needed. Review this carefully to verify accuracy.

Track tax and insurance changes. If you switch insurance providers or receive a property tax reassessment notice, inform your lender immediately so they can adjust your escrow payments.

Budget for increases. Property taxes tend to rise over time. Build a savings buffer to accommodate potential payment increases without straining your budget.

Keep documentation. Save copies of your tax bills, insurance policies and escrow statements. These records help you verify that payments were made correctly.

Contact your lender. Reach out to your loan servicer right away if you notice discrepancies or have questions about your escrow account. Your Pennymac Loan Expert is here to help you understand your statement and address any concerns.

FAQs About Mortgage Escrow Accounts

Is Escrow The Same As A Down Payment?

No. A down payment is the upfront money you pay toward your home's purchase price at closing. An escrow account for your mortgage is an ongoing fund that covers property taxes and insurance. During the homebuying and loan process, you may also hear "escrow" used to describe the third-party account that holds your earnest money deposit until closing — this is different from your mortgage escrow account.

Can Escrow Increase Without Notice?

Your lender must notify you of any changes to your escrow account through your annual escrow statement. However, the underlying costs (property taxes and insurance premiums) can increase throughout the year. When this happens, your lender will adjust your monthly payment to reflect the new amounts. You'll receive written notice of any payment changes.

What Happens To Escrow When You Refinance Or Sell?

When you sell your home or pay off your mortgage, any remaining escrow funds are refunded to you. The refund is typically issued within 15 to 20 days from the date of the payoff transaction.

If you refinance with Pennymac and currently have a Pennymac mortgage, you can use your existing escrow funds toward closing costs on your new loan. Other lenders will send you a refund check after your old loan is paid off, which can take several weeks.

Understanding Escrow for a Smoother Homeownership Experience

By dividing annual property expenses into smaller monthly amounts, escrow helps make your overall housing costs easier to plan and manage. While your payment may fluctuate as taxes and insurance costs change, the convenience and peace of mind that come with automated payments make escrow a valuable tool for most homeowners.

If you have questions about your escrow account or want to explore your mortgage options, connect with a Pennymac Loan Expert who can provide expert guidance and support.