If you have a mortgage, you almost certainly have an escrow account. Each month, your mortgage servicer collects extra money on top of your principal and interest to cover property taxes and homeowners insurance. When those bills come due, the servicer pays them from the escrow account. It sounds simple, but the details affect your monthly payment and can cause confusion when adjustments happen.
An escrow account (also called an impound account) is a holding account managed by your mortgage servicer. Each month, you pay 1/12 of your estimated annual property taxes and 1/12 of your annual homeowners insurance premium into this account. When the tax authority sends a bill or your insurance premium is due, the servicer writes the check from the escrow balance.
The purpose is to ensure taxes and insurance are always paid. If you defaulted on property taxes, a tax lien could take priority over the mortgage — putting the lender's investment at risk. If your insurance lapsed and the house burned down, the lender's collateral is destroyed. Escrow protects the lender by removing the risk that borrowers will skip these essential payments.
Most conventional loans with less than 20% down require escrow. FHA and VA loans always require escrow. Some borrowers with 20% or more equity can request escrow waiver and pay taxes and insurance directly, though the lender may charge a fee (typically 0.25% of the loan balance) for this option.
Your servicer estimates the total annual cost of property taxes and insurance, divides by 12, and adds that amount to your monthly mortgage payment. For example, if your annual property taxes are $4,200 and your insurance is $1,800, your total annual escrow need is $6,000 — or $500/month added to your P&I payment.
The servicer also maintains a cushion, typically equal to 2 months of escrow payments. This buffer protects against unexpected tax increases or insurance premium hikes. In our example, the cushion would be $1,000 (2 x $500), bringing the initial escrow funding to approximately $7,000 in the first year.
At closing, you prepay several months of taxes and insurance into the escrow account to build the initial balance. The exact amount depends on when you close relative to the next tax and insurance due dates. This is why closing costs include a line item for escrow reserves — it is not a fee but rather advance deposits into your own escrow account.
Every year, your servicer performs an escrow analysis comparing what was collected to what was actually paid out. If taxes or insurance increased, the servicer adjusts your monthly escrow payment for the coming year. This is the most common reason your mortgage payment changes from year to year.
A shortage occurs when the account balance is projected to go below the required minimum cushion. If your property taxes increased by $600 and your insurance went up by $300, you have a $900 shortage. The servicer will increase your monthly payment by $75/month ($900 divided by 12) going forward, plus spread the current shortage over 12 months. This can increase your total payment by $100-$200 or more.
If the account has more than $50 above the required cushion, the servicer must refund the excess to you. This can happen if you overpaid during the previous year or if your taxes or insurance decreased. Surpluses are refunded by check, usually within 30 days of the annual analysis.
A deficiency means the account balance is currently negative — actual costs exceeded what was collected. The servicer covers the difference but requires repayment. If the deficiency is less than one month's escrow payment, it must be absorbed into next year's payments. If larger, the servicer may offer a repayment plan over 12 months.
Homeowners with fixed-rate mortgages are often surprised when their monthly payment changes. The fixed rate only applies to the principal and interest portion. The escrow portion — and therefore the total payment — changes whenever property taxes or insurance premiums change.
In areas with rapidly increasing home values, annual property tax reassessments can drive significant escrow increases. A home that appreciated 20% in two years might see property taxes jump by a corresponding amount, adding $100-$300/month to the escrow payment. Insurance premiums have also been rising sharply nationwide — 10-30% annual increases are common in storm-prone states.
This is why budgeting for homeownership should account for annual increases in taxes and insurance, even on a fixed-rate mortgage. A reasonable assumption is 3-5% annual increases in taxes and insurance, which translates to your total housing payment rising $50-$150 per year in most markets.
The Real Estate Settlement Procedures Act (RESPA) governs escrow accounts and provides several protections. Your servicer cannot require an escrow cushion of more than 2 months of payments. The servicer must conduct an annual analysis and send you a detailed statement. If there is a surplus over $50, it must be refunded within 30 days.
If you believe there is an error in your escrow account, you can send a qualified written request to your servicer. They must acknowledge receipt within 5 business days and respond within 30 business days. During the investigation, the servicer cannot report adverse information to credit bureaus related to the disputed amount.
You can also request an escrow account waiver if you have at least 20% equity (some lenders require 25%). If approved, you pay taxes and insurance directly. This gives you more control over timing and cash flow but requires discipline — you need to set aside the money yourself and pay bills on time. Missing a tax or insurance payment can have serious consequences.
Review your annual escrow analysis statement carefully. Verify that the property tax amount matches your actual tax bill and the insurance premium matches your renewal declaration. Errors happen — the servicer might use a projected amount that differs from reality.
If you receive a new property tax assessment that is significantly higher than expected, appeal it before it gets baked into your escrow. A successful appeal reduces your taxes and prevents the corresponding escrow increase. Similarly, shopping for cheaper homeowners insurance directly reduces your escrow payment.
When you receive an escrow shortage notice, you have the option to pay the shortage in a lump sum rather than spreading it over 12 months. This prevents the temporary payment spike and keeps your monthly payment lower going forward. If the shortage is $1,200, paying it all at once is often easier than absorbing an extra $100/month for a year on top of the adjusted escrow amount.