An escrow account is first established when you close on your mortgage. At this point, part of your closing costs will be to pay for the first year of insurance, unless you pre-paid that premium. Added to closing costs will also be a reserve that is deposited into your escrow account, partially for the next property tax payment that is due and partially to provide a buffer in case taxes or insurance rates rise.
Starting with your first mortgage payment on your new home, you will be paying one-twelfth of your annual insurance premium, which will then sit in your escrow account until your policy renews a year later. In this manner, basically you are always paying your Homeowners insurance one year ahead. Similarly, your monthly payment also includes one-twelfth of your annual property tax bill, which will also be held in your escrow account until the next tax due date.
It is very important to understand that while your monthly principal and interest payment may be fixed for the life of your loan (as long as you continue to pay on time), the additional amount going to your escrow account is very likely to change down the road. This is because property taxes and Homeowners insurance rates do change over time – unfortunately going up more often than they go down. If amount due changes for either, your mortgage company will have to also adjust the monthly amount they collect from you. This means that your total monthly mortgage payment will not always stay the same as time goes on.
While an escrow account is not required for every mortgage, many special mortgage programs do require it, including programs often utilized by first time homebuyers. If you are not using a special mortgage program then your relative level of risk will determine if the escrow account is mandatory. For example, an escrow account is usually required when paying less than twenty percent down.
Why do mortgage companies want an escrow account? It’s because your home is the collateral for the loan they make you. Meaning that if you don’t continue paying they can recoup their loss by foreclosing and then selling your home. But if they had to foreclose and then found that that the home was damaged and you didn’t have insurance in force - or they found a tax lien against your home because you didn’t pay your property taxes when due - this would affect their ability to recoup their loss after foreclosure.
If an escrow account is not required by your mortgage company, you may have the choice to opt in or opt out. Many people do voluntarily opt in as a matter of convenience, to avoid having to come up with large chunks of money two or three times a year when taxes and/or insurance become due. (While most Homeowners policies do provide a monthly payment option, property taxes are typically due in the two installments in the spring and fall.)
Never forget that the funds in the escrow account belong to you. If you pay off your mortgage, any balance in the account will be refunded to you.
One final word: Although your mortgage company may stay in control of paying for your insurance, you are still in control of selecting insurance; you get to choose your carrier, coverages and deductible, subject to their basic requirements. You also have the right to change your insurance provider down the road if you so choose.