Types of Escrow Accounts
Before tackling your escrow shortage head-on, it’s important to know what escrow is and to understand the difference between the two types of escrow accounts.
Escrow is a legal arrangement where an outside party—in this case, a mortgage lender or loan servicer—holds a large sum of money until a specific condition has been achieved. The specific condition you need to achieve before your escrow account can be closed depends on which type of escrow account you have.
The first type of escrow account is set up when you first purchase or refinance your home.
Before closing on a home, most homebuyers make a good-faith deposit (also known as “earnest money”). Since you make this payment before you close on your new home, an escrow account is created to protect the deposit, the home buyer, and the seller until the purchasing process is complete. Escrow accounts created during the home-buying process essentially hold onto earnest money while it is neither yours nor the sellers.
Once you close on your home, the deposit will be used toward your down payment. If you don’t end up purchasing the home, the real estate agency or seller will use the deposit to cover the costs associated with relisting the home. The funds in this type of escrow account may stay there after closing for various reasons based on your agreement with the seller. If you are building a new home rather than purchasing a home from a real estate agent, funds may remain in your escrow account until you finish signing off on all the work to be completed for your new home.
The second type of escrow account is set up to be used for the duration of your home loan, rather than during the purchasing process.
Your mortgage company or home loan servicer may require you to have an escrow account to cover the additional costs of owning a home, aside from the cost of your mortgage loan. These additional costs may include your homeowners insurance and any additional insurance policies you need (like flood or earthquake insurance), real estate taxes or ground rent (depending on whether you own the land), and private mortgage insurance (if you are required to hold a PMI policy).
This means that when you make your monthly mortgage payment, it will include your mortgage rate and these additional costs, like property taxes and home insurance. Your mortgage company sets aside the portion of your payment intended for paying your home insurance company and additional monthly payments and places these funds into your escrow account.
The mortgage lender then takes this money and makes disbursements to pay for your homeowners insurance premiums and real estate taxes. This makes the payment process simpler for the homeowner, since you don’t need to worry about making your insurance payments or calculating your property or county taxes. After you send your monthly mortgage payment to your mortgage lender, your work is done.