An escrow account is an account established to hold funds prior to disbursement for a particular purpose. The two types of escrow accounts most commonly known in the United States are both related to real estate transactions and ownership. The first is established to hold funds, usually from the purchaser of property, until the time when ownership actually transfers, at which point the funds are disbursed. The second is established and maintained by the mortgage lender of a property. The homeowner makes regular payments into this account for property tax and homeowner's insurance payments.
The escrow account maintained in conjunction with the purchase of property is established and maintained by the purchaser's attorney in some jurisdictions, and by an escrow agent in others. When the purchaser makes an offer to buy a property, the offer is accompanied by earnest money, which is held in the escrow account until the sale is finalized and the escrow is closed. A strict accounting of all funds is rendered at the time of the closing, including the disposition of the funds in escrow.
When real estate is purchased, the owner assumes an obligation to pay real estate taxes in a timely manner. In addition, most mortgage companies require that the homeowner purchase and maintain homeowner's insurance on the property to protect against loss. If the taxes aren't paid when due, a tax lien may be placed on the house for back taxes, jeopardizing the mortgage company's interest in the house. Likewise, if the homeowner's insurance lapses, and a loss occurs, the mortgage company's investment is similarly jeopardized. Thus, it's in the mortgage company's interest to make certain that property tax and homeowner's insurance are paid on time and in full.
To accomplish this, most mortgage companies will require that the homeowner make monthly payments into an escrow account from which the taxes and insurance premiums will be paid. When the mortgage is first issued, the homeowner pays an amount &emdash; usually two months' of tax and interest payments &emdash; after which regular monthly payments are made with the monthly mortgage payment. When the tax bill or insurance premium is due, payment is made by the mortgage company out of the escrow account. An advantage to this sort of arrangement is that the homeowner doesn't have to be concerned with keeping track of those payments.
A particular advantage of paying taxes and insurance through an escrow account is that the payments, when due, may put a strain on the homeowner's budget, since tax bills are generally due quarterly and homeowner's insurance premiums are usually payable annually. The escrow system lets the money build in an untouched account and relieves the homeowner of having to gather the funds to pay insurance and taxes. A drawback of the escrow system is that funds in escrow generally don't pay interest to the homeowner, who is technically the owner of the funds until they're disbursed.
Homeowners must also review carefully their monthly mortgage statements and periodic statements of the activity in the escrow account. Errors in escrow accounts are not uncommon, especially when mortgages are transferred from one bank to another, and if errors aren't caught in time, there's often no recourse for the homeowner.
Escrow accounts may sometimes be established for other purposes. For instance, loan proceeds for construction of a house will be held in escrow and disbursed upon the completion of particular phases of the construction. The funds are held in escrow to guarantee to the builder that they're actually available, as well as to ensure that the work is performed satisfactorily before the funds are released. In fact, whenever either performance or payment is an issue, an option is to establish an escrow account in the custody of a trusted third party, to be released upon satisfactory performance.