You'll find when you are purchasing a home that the word "escrow" gets thrown around a lot. You may hear of an escrow account, funds being held in escrow, or someone may even refer to the escrow period or escrow being open. What does all this mean? Well, escrow basically means "in the custody of a third party." When we talk about an escrow account we are talking about funds being held and disbursed by a third party on behalf of their owner.

For most borrowers, a portion of the monthly mortgage payment goes toward paying property taxes and homeowners' insurance. Every month these funds are paid into an escrow account managed by the lender. The lender will then pay the property taxes and homeowners' insurance bill when they are due using the funds from this account. This protects the lender as it ensures that these essential bills are paid on time and it means the homeowner doesn't have to worry about managing these payments.

As part of the closing costs when purchasing a home a buyer will pay into the escrow account to establish it. Homeowners' insurance is paid yearly and the first payment is due on the date of closing. So the buyer pays the first year up front as well as depositing about 3 months of insurance payments into the escrow account. The buyer deposits a few months of property taxes into the escrow account as well. The amount of property taxes deposited depends on the time of year of closing in relation to when the tax bill is due.

Typically the lender will re-evaluate the escrow account on a yearly basis. They will adjust the amount of the monthly payment to cover any changes in the cost of insurance or property taxes. With a fixed rate mortgage this is the only way your payment will ever change. If the lender finds that there is too little money in the account to cover all payments due, they may adjust your monthly mortgage payment to cover the difference or give you the option to pay a lump sum into your escrow account to make up the shortage. In the event of an overage the lender will typically cut you a check for any funds not needed.