Why lenders require escrow accounts

Lenders require escrow accounts primarily to reduce risk and protect collateral. For mortgage loans, the lender’s collateral is the home; unpaid property taxes or lapsed hazard insurance can create liens or expose the property to loss, which increases the lender’s risk. By collecting predictable amounts each month and paying those bills directly from an escrow account, servicers and lenders reduce the chance of tax liens, insurance lapses, and surprise large bills that could threaten repayment (Consumer Financial Protection Bureau, https://www.consumerfinance.gov/ask-cfpb/what-is-an-escrow-account-en-1322/).

In my practice as a financial educator, I’ve seen transactions where escrow prevented costly outcomes — for example, a borrower who forgot to renew hazard insurance after a storm. The escrowed insurance payment avoided an uninsured loss and a potential default dispute.

How escrow accounts work in real estate and lending

  • Setup: Escrow is established at contract signing or loan closing. For purchases, the buyer’s earnest money is deposited; for mortgages, the servicer sets up an escrow account to collect periodic amounts for taxes and insurance.
  • Monthly collection: The servicer estimates annual bills and divides them into monthly portions that are added to the mortgage payment.
  • Payment and reconciliation: The servicer pays taxes and insurance when due and performs an annual escrow analysis to reconcile actual expenses with collected amounts.
  • Shortages and surpluses: If expenses exceed what was collected, the account shows a shortage. The servicer can ask the borrower to pay the shortage as a lump sum or spread it over future payments. A surplus above a regulatory threshold must typically be returned or credited per federal rules (see CFPB explanation).

Common types of escrow arrangements

  • Real estate purchase escrow: Holds earnest money and closing funds until deed transfer and contingencies are satisfied.
  • Mortgage escrow (tax and insurance escrow): Collects property tax, homeowners insurance, and sometimes mortgage insurance or HOA dues.
  • Escrow holdbacks: Funds set aside after closing to guarantee repairs or to satisfy outstanding title issues.
  • Legal and transactional escrow: Used in settlements, mergers, or business acquisitions to secure performance or indemnity obligations.

What lenders typically require from borrowers

Lenders often require escrow accounts on these mortgages or buyers:

  • Conventional loans with less than 20% down: Many lenders require escrow to reduce risk.
  • Government loans (FHA, VA): Frequently require escrow for taxes and insurance; FHA rules allow servicers to maintain a cushion (up to two months) to manage timing differences.
  • Loans with higher perceived risk: New borrowers, investment properties, or borrowers with lower credit scores may be asked to escrow.

Some qualified borrowers can request an escrow waiver (for a fee) on certain conventional loans. To learn typical waiver conditions and lender policies, see our guide on Escrow Waiver Conditions (https://finhelp.io/glossary/escrow-waiver-conditions/).

What escrow covers (and what it doesn’t)

Escrow commonly covers:

  • Property taxes
  • Homeowners (hazard) insurance premiums
  • Private mortgage insurance (PMI) and some servicers’ HOA dues in case of escrow agreements

Escrow does not change your tax responsibilities or insurance rights — it simply manages the timing of payments. Payments made from escrow for property taxes remain the homeowner’s tax payments; deductibility follows the normal IRS rules (see IRS Publication 530 for homeowners, https://www.irs.gov/publications/p530).

For a focused look at what typical mortgage escrow accounts cover, see What an Escrow Account Covers in a Mortgage (https://finhelp.io/glossary/what-an-escrow-account-covers-in-a-mortgage/).

Escrow analysis, cushions, and federal rules

Federal rules require servicers to perform an annual escrow analysis and to provide borrowers with a statement that explains shortages or surpluses. Under federal regulations (Regulation X implementing RESPA), servicers can maintain a cushion — commonly up to two months’ worth of escrow payments — to prevent small timing differences from creating repeated shortages. The CFPB outlines how servicers handle escrow analyses and disclosures (CFPB: escrow analysis guidance).

Practical note: I often advise clients to review the annual escrow statement carefully. A growing surplus or recurring shortage usually signals that the servicer’s estimates are off — or that property taxes or insurance premiums have increased.

Escrow shortages and how to handle them

Common causes of shortages:

  • Property tax increases or reassessments
  • Annual homeowners insurance premium increases
  • Failure to account for special assessments or HOA dues

Ways shortages are handled:

  • Lump-sum payment at notice
  • Spread over the next 12 months (increased monthly escrow portion)
  • Escrow account review and correction if servicer miscalculated

If you receive an escrow shortage notice, compare the servicer’s numbers to your tax bill and insurance invoice. Dispute obvious errors in writing and keep copies of your bills. For guidance on shortages and payment options, see Understanding Escrow Shortages and Your Mortgage Payment (https://finhelp.io/glossary/understanding-escrow-shortages-and-your-mortgage-payment/).

Fees, costs, and who pays for escrow services

Escrow fees vary. For purchase escrows, closing costs often include escrow/settlement fees paid to the title or escrow company for handling funds and paperwork. Mortgage escrow accounts typically don’t charge a monthly fee to the borrower — the servicer includes the escrow collection as part of the mortgage servicing. However, closing-time setup can require an initial deposit (e.g., a few months of escrow plus cushion).

Negotiation tip: In purchase transactions, escrow/closing fees are negotiable — they can be paid by the buyer, seller, or split as agreed in the purchase contract.

Practical examples

Example 1 — Purchase escrow: A buyer deposits earnest money into escrow. The escrow agent confirms clear title and release conditions. After inspection contingencies and title review are satisfied, funds are disbursed at closing.

Example 2 — Mortgage escrow: On a $300,000 home, annual property taxes of $3,600 and insurance of $1,200 mean $4,800/year. The servicer collects $400/month ($4,800 ÷ 12) in addition to principal and interest to fund the escrow account.

Common mistakes and misconceptions

  • Mistake: Treating escrow as the lender’s money. Reality: Escrow holds your funds for specific bills; you retain responsibility for those bills even though payments are managed by the servicer.
  • Misconception: Escrow eliminates tax deductions. Reality: The method of payment (escrow) doesn’t affect eligibility for deductions under IRS rules.
  • Mistake: Ignoring the annual escrow analysis. Regular review catches increases in taxes or insurance early.

When escrow can be waived (and when it can’t)

Some lenders offer escrow waivers to low-risk borrowers, usually for a fee. Waivers are more common for borrowers with substantial equity and strong credit on conventional loans. Government-backed loans usually require escrow for tax and insurance payments. See our article on Escrow Waiver Conditions for typical lender policies (https://finhelp.io/glossary/escrow-waiver-conditions/).

Legal, title, and tax considerations

  • Title protection: Purchase escrows typically coordinate with title companies to ensure liens are cleared before closing.
  • Tax timing and deductibility: Because escrow simply pays taxes on your behalf, consult IRS Publication 530 (https://www.irs.gov/publications/p530) or a tax advisor to confirm whether your payments are deductible.
  • Regulatory protection: Federal rules require clear disclosures about escrow accounts and how servicers must handle analyses and shortages (see CFPB guidance).

Professional tips

  1. Keep copies: Save escrow statements, tax bills, and insurance invoices to verify servicer calculations.
  2. Check estimates early: Ask for a projected escrow account worksheet before closing so you understand initial deposits and monthly amounts.
  3. Shop servicers: If you suspect poor servicing, you can request information from the servicer and escalate complaints to the CFPB (https://www.consumerfinance.gov/complaint/).
  4. Consider escrow protections: For high-risk properties (e.g., flood zones), escrowed insurance ensures continuous coverage and avoids denial of future claims.

FAQs

  • Who controls the escrow funds? The escrow agent or loan servicer controls disbursement according to the agreement and applicable law.
  • Can escrow payments be changed? Yes — annual escrow analyses can adjust monthly escrow portions for taxes and insurance changes.
  • Are escrow funds insured? Funds are typically held in an insured bank account or trust; confirm details with the escrow company or servicer.

Final takeaways

Escrow accounts are a risk-management tool: they protect lenders’ collateral, help homeowners avoid lapses in insurance or tax payments, and add predictability to large annual bills. Review statements closely, understand how shortages are handled, and, when in doubt, get written explanations from your servicer.

Professional disclaimer: This article is educational and not personalized financial, tax, or legal advice. Consult a qualified tax advisor, attorney, or mortgage professional for advice about your specific situation.

Sources and further reading

Author: Senior Financial Content Editor & AI Optimization Agent, FinHelp.io. In my 15+ years educating borrowers and advising clients, escrow clarity prevents many later disputes and creates smoother closings.