Let’s say you’re buying a home when your lender tells you that you need an escrow account. Would you know what that is and why you need it?

Don’t worry. Escrow accounts are a fairly common practice when making a home purchase. They can even make your life easier when it comes to paying many of the extra expenses that come with buying a home. Let’s take a closer look at how escrow, home insurance, and other costs work together.

What is an escrow account?

An escrow account is a reserve where money is held during a real estate transaction until certain requirements are met. Typically, a third party, like an escrow company or a mortgage servicer, serves as a go-between and manages the account.

You may need an escrow account when buying a house to:

• Protect good faith money, ensuring it’s released to the seller of the home when the contractual terms are met.
• Hold on to funds you can use to pay your home insurance and property tax.

How does an escrow account work?

Escrow accounts are really not that complex in nature – they’re essentially holding accounts. Your money sits in escrow until you’ve either met the terms of a contract or your mortgage servicer needs it to pay bills.

Take the first example. In that scenario, you put your deposit in an escrow account to show that you’re serious about buying the home. The seller gets to keep that money if you back out, but it goes to your down payment if the sale goes through as planned.

In the second example, your mortgage company has established an escrow account after you purchased a home. It then puts some of your monthly mortgage payment into the account until your property taxes and home insurance premiums are due. When you have this type of escrow account, you make one payment for your mortgage, insurance, and property taxes, and the escrow company pays the appropriate party as required.

You should note that escrow accounts usually don’t earn interest. As a result, you want to think carefully about whether using escrow to pay home insurance is a good idea for you.

Does escrow pay home insurance?

If you have an escrow account, you likely pay your home insurance bill through it. This usually means you pay a portion of your insurance premium every month with your mortgage payment so that there’s money in the escrow account when the annual premium is due. Basically, you’re prepaying your home insurance bill.

Lenders like using escrow accounts because they reduce the risk of a homeowner defaulting on a home because they either forgot to pay or didn’t save money for their home insurance or property taxes.

Lenders contractually require homeowners to keep valid home insurance. This protects the lender’s financial interest in a home because they know it can be rebuilt and retain its market value if there’s a major loss. Lenders have a similar interest in making sure homeowners pay their property taxes. A city may be able to foreclose on properties delinquent in taxes. Requiring property taxes be paid through an escrow account reduces this risk, too.

Do I have to pay homeowners insurance through escrow?

Whether or not you use escrow to pay home insurance depends on the contract you signed with your lender. If your lender requires an escrow account, then you most likely have to pay your insurance through it. If your lender does not require an escrow account, then you can choose to pay insurance through an escrow account or directly to your homeowners' insurance company.

Even if your mortgage servicer requires you to set up a home insurance escrow account, you get to decide who you want to insure your home. You still need to pick a company that meets your lender’s requirements, but other than that, the choice is yours.

Perhaps more importantly, you can shop around for a new insurance company even if your escrow account has already been set up. When you do this, you send the new insurance information to the lender, who changes the insurance company. This may require a down payment and some escrow adjustments to ensure you have sufficient funds, but you might also receive a prorated refund from your former insurance company.

Get more detailed information in our article How to change homeowners insurance with an escrow account.