What is escrow?

Key takeaways

• An escrow account is used to hold the deposit of the earnest money from a prospective buyer. It also is a separate account used to hold funds for a homebuyer’s property taxes and homeowners insurance after closing.
• Escrow protects and simplifies the process: It acts as a neutral third party during the sale and later helps homeowners budget by spreading large tax and insurance bills over monthly payments.
• Most buyers can’t opt out of escrow: Government‑backed loans require it, and even when allowed, lenders often demand a larger down payment to let borrowers pay taxes and insurance on their own.

"Escrow" is one of the many confusing terms hurled at consumers during the homebuying process, and it takes on a different meaning depending on which stage you are in.

An escrow account keeps your money safe during one of the biggest financial transactions of your life. There are two kinds of escrow accounts: one when you buy and another when you take out a mortgage.

When your offer is accepted, escrow is the deposit you put down, often called "earnest money."

Usually, it’s 1 percent of the purchase price, said Mackenzie Douglas, a real estate agent at Maryland-based Douglas Realty, though buyers can put down more to make their offer stand out. The money is credited at closing, when the seller gets the purchase price and the buyers are given the keys to the home.

A second, separate escrow account is set up at closing, this time by your lender to save up monthly payments for property taxes and home insurance.

The initial amount is usually a year of tax payments and 13 months of home insurance, said Jordan Nutter, vice president of Creator Collective, a producer for NFM Lending. The extra amount for home insurance is because lenders typically skip the month of closing and the following month before sending your first mortgage bill, Nutter said.

That means you only make 10 payments during your first year as a homeowner, she said.

The lender holds two months of payments to make that even and an extra month to cover unexpected increases in taxes or insurance.

It’s a good-faith deposit.

It’s also a neutral third party that ensures the money gets to the right place. “It keeps things clean,” said Rebecca Chambliss, a real estate agent for Palm Realty Boutique in Los Angeles.

During the loan, escrow cushions the blow of tax and insurance bills, expenses that can come once a year, said Nydia Torres, a mortgage adviser with One Real Mortgage in San Antonio. “I see it as a budget tool. It allows you to save so you don’t have to pay in a big chunk at the end of the year.”

It’s also convenient because your lender usually pays those bills, setting aside money from each mortgage payment.

Generally, you can’t if your loan is insured by the federal government, like an FHA loan, said Mandy Phillips, a mortgage banker and branch manager at Omega Mortgage Group. If you are allowed to handle these yourself, lenders may ask you to put more money down for your deposit, often 10% or 20% in lieu of an escrow account, Phillips said.

Buyers who make their own payments often put the cash in a high-interest bank account until the bills arrive, Nutter said.

The lender holds onto your cash because you gave it the responsibility of paying the taxes and insurance, Nutter said.

Plus, they’re lending you the money for your mortgage.

Here are some definitions you should know when buying a home.