What is a Mortgage Escrow Account?

Written by Nickel - 7 Comments

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I recently received an e-mail from a reader who is interested in paying off her mortgage early. In it, she asked the following:

Is it better to pay money monthly that is applied to your escrow or your principal? I would like to pay the equivalent of one extra mortgage payment a year, but I’m not sure where to apply it.

The short answer is that you want the extra payments to apply to your mortgage principal — that’s the amount that you still owe the lender. In most cases, your lender will automatically apply any overage to your mortgage principal. That’s not always the case, however, so it’s best to check with them to be sure.

The longer answer is that your monthly mortgage payment likely consists of four parts: principal, interest, taxes, and insurance. This is where the acronym PITI comes from. The reason that your lender collects taxes and insurance is that they want to protect their investment (your home) from both disaster and tax complications by making 100% sure that both bills get paid.

What the heck is escrow?

So where does escrow come in? Well… The term escrow refers to a legal arrangement in which a third-party takes possession of money or property until certain obligations have been met. In the real estate world, the “extra” funds that your lender collects are placed in an escrow account until your tax and/or insurance bills come due. At that point, the funds are disbursed to cover your obligations.

More generally, escrow services are often used to reduce risk in business deals when the two parties don’t fully trust each other. For example, if a particularly valuable asset is being sold, the buyer will often transfer their money to an escrow agent instead of paying the seller directly. The escrow agent will then hold the funds until the asset has been transferred, at which point the seller will get paid.

Published on August 26th, 2009 - 7 Comments
Filed under: Mortgages, Real Estate
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About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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Comments (scroll down to add your own):

  1. “principal, interest, taxes, and insurance”

    There are so many things I didn’t realize when I bought my house. I knew I’d be paying $671 for principal and interest and $40 for PMI, but didn’t know about the $226 for taxes and insurance. So the grand total is $937, a good deal more than the $671.

    Comment by Hatch — Aug 26th 2009 @ 9:10 am

  2. To make the equivalent of 1 extra payment per year you can either pay half the monthly amount every two weeks or increase each monthly payment by 1/12. Make sure to write on the check that you want the extra to go to principal.

    Comment by EZ — Aug 26th 2009 @ 10:17 am

  3. I also find that the escrow account is a great way for your mortgagee to fail at simple math. It definitely pays to keep tabs on the balances and your payments.

    Comment by Paul @ FiscalGeek — Aug 26th 2009 @ 11:18 am

  4. Escrow, while well intended, never seem to fit for me. I did it on my first house – came up short at property tax time, thus I had to out of pocket the rest. SUbsequent year PITI went up to avoid similiar outcome.

    On subsequent homes, I have done my own escrow. That is to say each month I pay Principal & Interest (and extra principal, but thats for another thread someday). Then I deposit 1/12th of our estimated taxes and home owner’s insurance into a high yeild money market (MM).

    This MM, also hold our cash reserves. So we make enough in interest each month to cover a utility bill, and then in Jan each year write the check to the applicalbe tax offices, with annual insurance premiums in June.

    It’s pretty simple, and helps with “Paying yourself first”.

    Comment by Bodark — Aug 26th 2009 @ 9:52 pm

  5. Hate to sound like the rude person, but the person really had no clue whether to apply extra payment towards principal or escrow? You figure at loan closing, they would go over your escrow.

    Comment by Tony — Aug 27th 2009 @ 3:08 pm

  6. Tony: Yes, and I’d be willing to bet that she’s not alone. That’s why I decided to write something up. It’s been my experience that, if one person asks, there are usually many others who are wondering the same thing. Personally, I’m glad that people are willing to ask these sorts of questions rather than being left to wonder.

    Comment by Nickel — Aug 27th 2009 @ 4:25 pm

  7. i am getting ready to pay our house payment from new coupon book and i see our house payment went down a little. i paid the reg. payment and then added $20 extra each month to be put in – sometimes escrow – sometimes principle. is this wise? the year before we had come up short on escrow for some reason and our monthly payment had gone up some. btw, math makes me dizzy so please make it real simple. thanks.

    Comment by barb — Sep 5th 2009 @ 11:35 pm

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