What is Escrow?
Escrow is a word you’ll hear frequently when applying for and closing on a VA loan, and it’s an important word for you to understand. This article is mostly for first-time homebuyers because most who have bought a house before will already have a sense of what escrow means, in general, and a very clear idea of what escrow means to them. Knowing what escrow means before you’re applying for a loan can save you time in the process and help make the process go a bit smoother. It can also help prevent nasty surprises from coming up during the process. So let’s jump into this; we’re going to go over the definition of escrow, then talk about what it means in the context of a mortgage and how it affects you.
Investopedia defines “escrow” as: “A financial instrument held by a third party on behalf of the other two parties in a transaction. The funds are held by the escrow service until it receives the appropriate written or oral instructions or until obligations have been fulfilled.” Since that doesn’t make any sense, allow me to explain with an analogy. When you go grocery shopping, you take your groceries and put them into the car, which is where they stay until you take them home. In this sense, your car is acting as an ‘escrow’ for the groceries. You can’t put the groceries directly from your shopping cart into your refrigerator, because your refrigerator is way too far away, so you put them in your car until your refrigerator is close enough that you can carry them to it from the car. This may seem a weird example, but an escrow works the same way; it is just an account where money is placed and stored up until the bill being saved up for comes due.
What is it used for?
In a mortgage, an escrow is usually used for property taxes and insurance (homeowners, sometimes flood or other additional). Those items are usually due annually, so your mortgage company sets up your payment to make a monthly contribution to the escrow so by the time the bill comes due you have enough money in the escrow to pay for it. Usually, the mortgage company takes care of paying it for you. Escrow is a legal and financial term, in that there are certain ways that a company is required to handle and treat escrow funds if they are officially being used for an escrow purpose, but many people use de facto escrows without even realizing it. You know those “rainy-day” funds you keep? That’s an escrow. Your new car fund? An escrow. Kids’ college fund? Escrow. So you already know and understand what an escrow is. In the context of a mortgage, the escrow is something that the mortgage company charges you to cover taxes and insurance.
How Does it Affect You?
Well, the most obvious way is that it makes your monthly payment higher because you’re paying X amount in taxes and insurance every year. Taxes & insurance can add hundreds of dollars to your monthly payment, and even after you completely pay off your home, you’ll still have to pay those every year. Escrows also make life easier for you, though. Rather than having to keep track of it yourself, make sure to save up enough, and make sure to remember to pay your taxes and insurance premiums every year, the mortgage company worries about that for you. It makes life a lot easier on you. Other than that, the escrow on a mortgage doesn’t really affect you. Be prepared to sign something during the process that authorizes the mortgage company to take some of your money and put it in escrow, though. As long as you’re expecting it and realize that it will be added to the monthly principal+interest payment you have painstakingly calculated in preparation for getting a mortgage, the escrow shouldn’t present any difficulties.
So there you have it, now you understand escrow and you are armed with the knowledge that you can take with you when you meet with a loan officer. The more knowledge you already have when you start the process of getting a loan, the more likely you’ll be able to get the best mortgage option available to you.