What Is Escrow and How Does It Work in a Mortgage?

Escrow appears in two very different contexts during a home transaction. Here is what each one means, how they work, and what to watch out for.

Escrow is one of those words that appears constantly in real estate and mortgage conversations — yet most buyers go through the entire home purchase process without fully understanding what it means. The confusion is understandable: "escrow" refers to two distinct things in a home transaction, and people use the word interchangeably without always specifying which they mean.

The two types of escrow in real estate

Purchase escrow is a neutral third-party account used during the home buying process. When you make an offer and the seller accepts, your earnest money deposit goes into escrow — held by a title company, escrow company, or attorney. Neither buyer nor seller can touch those funds until the transaction closes (or legally falls through). Purchase escrow protects both parties during the period between accepted offer and closing.

Mortgage escrow (also called an impound account) is an ongoing account your lender manages after you close. Each month, your mortgage payment includes amounts for property taxes and homeowners insurance. Your lender holds those amounts in the escrow account and pays the bills on your behalf when they come due. Most conventional loan borrowers with less than 20% down are required to have a mortgage escrow account.

How mortgage escrow works month by month

Your lender estimates your annual property tax and insurance costs, divides by 12, and adds that amount to your monthly payment. The escrow portion of your payment accumulates in the account until the bills are due — typically once or twice per year for property taxes and annually for insurance.

The lender is required to maintain a cushion — typically 2 months of escrow payments — as a buffer against unexpected increases. This means at closing you often prepay 2–3 months of escrow upfront, which is why closing costs include prepaid escrow amounts.

Escrow analysis: why your payment changes

Once per year your lender performs an escrow analysis — a review of actual tax and insurance costs versus what was collected. If your property taxes increased or your insurance premium rose, your escrow shortfall must be covered. The lender will either ask for a lump-sum payment to cover the shortfall or spread the difference over the next 12 months, increasing your monthly payment.

This is why your mortgage payment can increase even on a fixed-rate loan — the P&I portion stays flat, but the escrow portion adjusts annually. Most homeowners experience a $50–$200 annual payment increase due to rising property taxes over time.

Can you remove mortgage escrow?

For conventional loans, you can typically request escrow removal once your loan-to-value ratio reaches 80% — meaning you have at least 20% equity. Most lenders charge a fee of $200–$500 to waive escrow, and some lenders add 0.125–0.25% to your interest rate. Before requesting escrow removal, ask yourself whether managing separate quarterly or semi-annual property tax bills and annual insurance renewals is worth the small administrative benefit. Most homeowners find the forced savings mechanism of escrow more convenient than managing the payments themselves.

FHA loans require escrow for the life of the loan regardless of equity. VA loans have specific escrow rules depending on the lender. Check your loan terms before assuming escrow removal is available.

Purchase escrow: what happens to your earnest money

When your offer is accepted, your earnest money — typically 1–3% of the purchase price — goes into a purchase escrow account. This deposit demonstrates good faith to the seller and is credited toward your down payment or closing costs at closing.

The escrow funds are protected by the purchase contract contingencies. If the sale falls through because the home failed inspection, the appraisal came in low, or your financing was denied — and these contingencies are properly written into the contract — you typically get your earnest money back. If you back out of the purchase for a reason not covered by a contingency, the seller may be entitled to keep the deposit. This is why reviewing contingency language carefully with your real estate agent matters.

Frequently asked questions

Is escrow the same as a down payment?
No. Your down payment is your equity contribution toward the home purchase — it goes to the seller at closing. Escrow is a separate holding account. During the purchase process, your earnest money is held in escrow until closing. After closing, your ongoing escrow account holds monthly tax and insurance contributions that your lender pays on your behalf.

What happens to my escrow account if I refinance?
When you refinance, your old escrow account is closed and the balance is refunded to you — usually within 30 days of the refinance closing. Your new lender sets up a new escrow account, and you typically prepay 2–3 months of escrow at closing. Time your refinance with this refund in mind: you will have a gap period where you have paid into the new escrow but not yet received the old refund.

What if my lender pays my property taxes late from escrow?
This happens occasionally and can result in late payment penalties. Your lender is responsible for those penalties if the late payment was their error — the funds were in your escrow account and they failed to disburse on time. Document the issue and contact your lender in writing to have any penalties reimbursed.

Can I pay my own property taxes and insurance without escrow?
Yes, if your lender waives escrow and you have sufficient equity. You are then responsible for making quarterly or semi-annual property tax payments directly to your local tax authority and paying your annual insurance premium directly to your insurer. Missing either payment has serious consequences: unpaid property taxes can lead to a tax lien on your home, and a lapsed insurance policy violates your mortgage terms.

What to check when you receive your annual escrow analysis

Your lender sends an escrow analysis statement once per year. Most homeowners glance at the new payment amount and file it away. Spending 5 minutes actually reading it can save you money and prevent surprises.

Check these four things: First, the projected annual disbursements — this shows what your lender expects to pay for taxes and insurance in the coming year. Compare this to what was actually paid last year. A large increase warrants a call to confirm the figures are correct. Second, the required cushion — lenders are allowed to hold up to 2 months of escrow as a buffer. If the required cushion seems high, confirm it is within legal limits. Third, the shortage or surplus — if you have a shortage, understand whether it is because taxes increased, insurance increased, or the lender underestimated at closing. If you have a surplus of more than $50, you are entitled to a refund. Fourth, the new monthly escrow amount — confirm the math adds up: (projected annual disbursements + required cushion − current balance) ÷ 12 = monthly escrow payment increase.

If your property tax assessment seems high, you have the right to appeal it through your local assessor's office. A successful appeal can lower your assessed value and reduce your escrow payment for years going forward. This is worth pursuing if comparable homes in your area are assessed significantly lower than yours.

Earnest money: how purchase escrow protects both buyer and seller

During a home purchase, earnest money typically represents 1–3% of the purchase price and demonstrates the buyer's serious intent. It is held in a purchase escrow account — usually by the title company or an attorney — until the transaction closes or legally terminates.

The contingencies in your purchase contract determine what happens to earnest money if the deal falls through. An inspection contingency allows you to withdraw if the inspection reveals significant issues — and get your deposit back. A financing contingency protects you if you cannot obtain the mortgage you applied for. An appraisal contingency protects you if the home appraises below the purchase price. If you exercise any of these contingencies properly and within the stated timeframes, you get your earnest money refunded.

If you back out for a reason not covered by a contingency — you simply changed your mind, found another property, or missed a contingency deadline — the seller may be entitled to keep the deposit as liquidated damages. This is why understanding your contingency deadlines is critical. Real estate agents sometimes push buyers to waive contingencies in competitive markets; understand exactly what protection you are giving up before agreeing.

In very competitive markets, buyers sometimes offer larger earnest money deposits (3–5% rather than 1%) to signal stronger commitment to sellers. If you go this route, ensure your financing contingency is clearly written — a larger deposit at risk requires stronger contractual protection.

Common escrow mistakes and how to avoid them

Even though escrow runs largely on autopilot, a few common mistakes can cost you money or create unexpected problems.

Ignoring your annual escrow analysis. Most homeowners file it without reading it. A 2-minute review confirms your lender is using accurate tax and insurance figures. Errors in estimated disbursements — using last year's tax amount when your assessment increased significantly — can cause a large shortage the following year that you could have anticipated.

Not updating your insurance after a claim or renewal. If your homeowners insurance premium increases at renewal, your lender may not receive the updated figure until the next escrow analysis. This creates a shortfall. When your insurance renews, confirm your lender has the correct premium on file so the escrow payment adjusts promptly.

Assuming escrow covers everything tax-related. Your mortgage escrow covers property taxes — not income taxes, capital gains from a sale, or special assessment taxes levied by your municipality for local improvements like road work or utility upgrades. Special assessments are sometimes sent directly to the homeowner rather than the lender and must be paid separately. Check with your local government if you receive an unusual tax bill.

Forgetting to claim the escrow refund after selling or refinancing. When you sell your home or refinance, the escrow balance is refunded. This cheque sometimes goes to the old address or gets lost in the chaos of closing. Confirm the refund amount and delivery method with your servicer during the closing process so it does not get overlooked.