What is Escrow on a Mortgage and How Does it Work Vision Retirement financial advisor CFP fiduciary RidgewoodNJ

Escrow accounts play a crucial role in safeguarding and organizing financial transactions and are particularly important in real estate. Whether you're buying a home or managing ongoing mortgage payments, they help pave the way for a smooth, secure process! Let's learn more about them…

What is an escrow account?

An escrow account—a financial arrangement whereby a neutral third party holds funds or assets on behalf of parties involved in a transaction—plays a key role in safeguarding financial transactions, ensuring money is kept safe and not released until all parties involved have fulfilled their contractual obligations. This process adds a layer of security and trust while mitigating the risk of one party defaulting on the agreement.

In real estate, escrow accounts serve two main purposes:

During the home-buying process, these accounts hold earnest money deposits, deeds, and other essential documents until the transaction is completed: safeguarding the interests of both buyers and sellers while ensuring transparency and accountability throughout the process.
For ongoing property ownership, escrow accounts are used to manage funds for property taxes and homeowners’ insurance. Mortgage servicers collect these payments from the borrower in monthly installments and disburse them when bills are due, making it easier for homeowners to manage their financial responsibilities.

Beyond real estate, escrow accounts are also used in other transactions requiring trust between parties (e.g., for mergers and acquisitions, online purchases, and legal settlements whereby funds or assets must be held temporarily before conditions are met).

Escrow accounts are in fact a standard requirement for many loan types including Federal Housing Administration and USDA loans, maintaining compliance with applicable financial regulations, protecting lender interests, and facilitating efficient, secure transactions across a wide range of different financial dealings.

How escrow accounts work

Escrow accounts are vital for ensuring safe and successful home purchase transactions and managing ongoing property ownership responsibilities. Buyers and sellers can indeed enjoy peace of mind thanks to an escrow account, knowing their funds and obligations are handled securely and professionally.

For home buyers specifically, escrow accounts hold earnest money deposits provided by buyers as a sign of commitment to the transaction—with these funds remaining in escrow until conditions outlined in the purchase agreement are met (e.g., passing a home inspection or securing financing). Beyond deposits, escrow accounts may also hold deeds and loan proceeds.

After all requirements are fulfilled, the escrow agent disburses funds to the appropriate parties, transfers the deed to the buyer, and records the transaction with relevant authorities. Providing financial security to both parties, this structured method supports a seamless transfer of ownership.

With respect to ongoing property ownership, meanwhile, escrow accounts manage property taxes and homeowners’ insurance payments. Mortgage servicers collect a portion of these monthly costs as part of the borrower’s overall mortgage payment, with the funds held in escrow until tax and insurance payments are due.

Each year thereafter, then, an escrow analysis determines whether the account has collected enough funds—taking into account any tax rate or insurance premium changes. In the event of a shortfall, the servicer will cover the immediate payment and adjust future monthly contributions accordingly.

The account may also include an "escrow cushion," a small reserve amount regulated by law and typically capped at no more than two months' worth of payments to help account for potential fluctuations.

Different types of escrow accounts

Escrow accounts are categorized based on their purpose, primarily to assist homebuyers during transactions and to support homeowners throughout the life of a mortgage.

Escrow accounts for homebuyers

As mentioned earlier, homebuyer escrow accounts temporarily hold earnest money deposits demonstrating the buyer's intent to follow through with the transaction—with funds typically applied toward the buyer’s down payment or closing costs if the agreement proceeds to closing. Should a cancellation occur due to unresolved conditions (e.g., a failed inspection or appraisal discrepancy), the deposit may be refunded to the buyer. Conversely, should the buyer breach the agreement, the seller may retain the deposit as compensation.

Escrow accounts for homeowners

Homeowner escrow accounts are designed to manage ongoing property taxes and homeowners’ insurance payments throughout the life of a mortgage, with a portion of these expenses collected monthly by mortgage servicers to reduce the overall financial burden of lump-sum payments when bills come due.

Escrow holdbacks

Escrow holdbacks, a variation of the standard escrow process, are sometimes used in specific circumstances and may temporarily hold funds post-sale (e.g., when unfinished work remains on a property or when sellers are granted extended occupancy). For new home construction, escrow holdbacks can guarantee funds are released only when all agreed-upon contract conditions are satisfied.

Who manages escrow accounts?

Different entities manage escrow accounts depending on the stage of the transaction and the specific type of account, with each involved party playing a role in properly handling funds and documentation.

When buying a home, for example, escrow accounts are usually managed by escrow agents, title companies, or attorneys: professionals who serve as neutral third parties and hold earnest money deposits, deeds, and other important documents until all conditions of the purchase agreement are met.

Specific responsibilities include verifying all contractual obligations (e.g., inspections and financing approvals) are met before funds or documents are released. Escrow agents or title companies often work closely with buyers, sellers, and lenders to coordinate the closing process, ensuring all legal and financial requirements are satisfied.

With respect to managing ongoing accounts, mortgage servicers manage escrow payments collected as part of monthly mortgage payments: holding funds in escrow accounts and then disbursing property tax and homeowners’ insurance payments when due. Changes to property taxes or insurance premiums may require adjustments to monthly escrow contributions, a process managed through annual account analyses. In some cases, lenders sell the servicing rights of a mortgage to another company and in doing so transfer escrow account management to a new servicer.

Escrow account pros and cons

It's important to understand escrow account benefits and drawbacks for lenders and homeowners to know how these impact budgeting, payment terms/management, and overall financial responsibilities.

First and foremost, homeowner advantages include the convenience of automatic, timely payments for property taxes and insurance so property owners can avoid late fees and reduce the likelihood of liens from missed payments.

Spreading these costs into monthly mortgage installments also simplifies budgeting by removing the need to pay large lump sums when tax or insurance bills are due, a notable advantage for those who struggle to save for large, infrequent expenses.

The biggest reason escrow accounts benefit lenders, meanwhile, involves risk as they help ensure taxes and insurance premiums are paid consistently and on time: protecting the lender’s interest in the property since unmet obligations can trigger penalties, legal issues, or a decline in property value (all of which can adversely impact lenders).

Nevertheless, key disadvantages of escrow accounts include higher monthly mortgage payments due to escrow contributions and the need for borrowers to relinquish control over escrow funds—limiting their flexibility to manage finances as they see fit. The arrangement may also lead to a lack of awareness regarding rising tax assessments or insurance premiums, which might go unnoticed without direct oversight.

Finally, escrow fees often cost the home buyer between 1% and 2% of the home's purchase price and vary by lender. In some areas, buyers and sellers share this expense—making it more manageable for everyone involved—while in others one party may bear the entire cost. This further highlights the importance of clear communication and negotiation throughout the buying process.

Escrow account waivers

Some homeowners may qualify for escrow removal, often referred to as an "escrow waiver." Borrowers with conventional loans, for example, must typically have a loan-to-value ratio of 80% or lower (meaning more than 20% equity in their home) and an account in good standing to qualify for this removal. Pursuing this option requires careful budgeting and timely payments to avoid penalties or coverage gaps, and note that some types of loans (e.g., FHA loans) require escrow accounts and thus prevent homeowners from opting out of this requirement.

In sum: what is an escrow account on a mortgage

As you can see, escrow accounts play a vital role in transactions—particularly in real estate where they provide added peace of mind to all parties involved.

Have questions about escrow accounts and/or the home-buying process? Schedule a FREE discovery call with one of our CFP® professionals so we can help!

FAQs

Being “in escrow” refers to the period during a real estate transaction when a neutral third party holds funds and documents while conditions of the agreement are fulfilled, beginning when the seller accepts an offer and continuing until the closing process is complete.
Escrow accounts are mandatory for some types of loans including federally backed FHA and USDA loans (with conventional loans also requiring escrow if the down payment is less than 20%).
Opting out of an escrow account is sometimes possible under specific circumstances (e.g., maintaining a high credit score and a low loan-to-value ratio), but some loans (such as FHA loans) don't allow waivers.
Escrow accounts are typically limited to property taxes and homeowners’ insurance, with other home-related expenses (e.g., utility bills, homeowners’ association or HOA fees, and additional insurance policies) all falling outside the scope of escrow. These must be managed separately by the property owner instead.
An escrow shortfall or shortage—when insufficient funds are collected to cover taxes or insurance—task the lender with covering the immediate payment and adjusting future monthly payments to account for the shortfall. If an escrow overage is identified, meanwhile, the lender refunds the excess amount or applies it to future payments.
Escrow fraud occurs when scammers pose as lenders or escrow agents to steal funds using tactics such as fake emails, text messages, websites, or phone calls to collect login credentials or misdirect payments.
To prevent this, it's important to verify the sources of all communications received, avoid wire transfers to unfamiliar parties, and always contact lenders directly for confirmation. Taking these precautions can help safeguard against fraud.

About the author
The content in this post was developed by our team of writers and reviewed by our team of CFP® professionals here at Vision Retirement.

Retirement Planning | Advice | Investment Management

What is Escrow on a Mortgage, and How Does it Work?