What Is an Escrow Account, and Why Your Payment Changes

Many new homeowners are surprised when their mortgage payment changes a year or two after closing, even on a fixed-rate loan. The interest rate did not move. The escrow did. Understanding how an escrow account works, and the federal limits on it, turns that surprise into something you can predict.

1. What escrow is

The Consumer Financial Protection Bureau describes an escrow account, sometimes called an impound account, as an account your mortgage lender sets up to pay certain property-related expenses, mainly property taxes and homeowners insurance. Part of each monthly mortgage payment goes into the account, and your servicer pays those bills for you when they come due. Instead of facing a large tax bill once or twice a year, you pay a slice of it every month.

Many lenders require escrow so they can be sure the bills get paid, and in some cases it is required by law. Even if it is optional for you, the CFPB suggests considering it because it makes large bills easier to budget for.

2. How the monthly amount is set

Regulation X, the federal rule for mortgage servicing, sets the math. Throughout the life of the account, the servicer may charge a monthly amount equal to one-twelfth of the total annual escrow payments it reasonably expects to make. On top of that, it may add enough to keep a cushion no greater than one-sixth of the estimated total annual payments. One-sixth of a year is two months.

Here is an illustrative example:

So in this example, $550 is added to your principal and interest each month, and the servicer may hold up to $1,100 extra as a buffer.

3. Why the payment changes

The CFPB notes that property taxes and insurance premiums can change from year to year, and your escrow payment, and therefore your total monthly payment, changes with them. Each year, the servicer runs an escrow analysis and must send you an annual escrow statement within 30 days of the end of the escrow computation year.

Suppose the property tax bill in the example rises from $4,800 to $5,400. The new annual total is $7,200, so the regular monthly deposit becomes $600 instead of $550. If the account came up short for the past year as a result, that shortage is a separate amount to make up.

4. Shortages, deficiencies, and surpluses

Regulation X sets out what a servicer can do after the analysis:

• Shortage of less than one month's escrow payment: the servicer may do nothing, ask you to repay it within 30 days, or ask you to repay it in two or more equal monthly payments.
• Shortage of one month's payment or more: the servicer may do nothing or require repayment in equal monthly payments spread over at least 12 months.
• Surplus of $50 or more: if you are current on your payments, the servicer must refund it within 30 days of the analysis. A surplus under $50 may be refunded or credited against next year's payments.

In the example, if a $600 shortage built up, spreading it over 12 months adds $50 a month, so the escrow part of the payment could go from $550 to $650 for the next year: $600 for the new base amount plus $50 to catch up.

5. If you do not have escrow

If your loan has no escrow account, you pay taxes and insurance yourself. The CFPB warns that failing to pay property taxes can lead to fines, penalties, or a tax lien, and in serious cases foreclosure. If insurance lapses, the lender may buy force-placed insurance for you, which is typically more expensive than a policy you buy yourself.

6. How to stay ahead of it

• Read the annual escrow statement when it arrives; it shows the projected bills and any shortage or surplus.
• When your property tax assessment or insurance premium rises, expect your payment to rise at the next analysis.
• If a shortage appears, ask whether you can pay it in one lump sum to keep the monthly payment lower.
• Keep your homeowners insurance renewal notices so you can check the amounts the servicer is using.

7. Key takeaways

• Escrow collects property taxes and insurance with your mortgage payment, and your servicer pays those bills.
• Federal rules allow a monthly deposit of 1/12 of expected annual bills plus a cushion of up to 1/6 of the annual total.
• With $6,600 a year in taxes and insurance, the deposit is $550 a month and the maximum cushion is $1,100.
• Shortages of a month or more can be spread over at least 12 months; surpluses of $50 or more must be refunded if you are current.
• A fixed-rate payment can still change because taxes and insurance change.