When you begin the journey of buying your first home, you are going to hear so many new terms you might think you’ve landed in a college finance class.  As with most industries, certain phrases are used differently by different parties. Some of the most common confusions revolve around the terms; escrow, escrow account, impounds, and prepaids.  

This article aims to explain any differences between the terms so you can keep your head screwed on straight during this stressful time.  

What is Escrow?

Escrow is a term you hear in mortgage and real estate conversations. We’ll clarify the difference between the various terms you might hear understand the difference between escrow (the third party responsible for executing the sale contract) and escrow accounts (accounts held on your behalf to pay insurance, property taxes and any applicable mortgage insurance).

Opening escrow means that you have officially started the buying process. An Escrow company has opened a file between you, the buyer, and the seller of the property.

Escrow companies charge an “escrow” fee that you will see itemized out on a lending estimate or closing statement. Escrow companies are the third parties responsible for executing the contract. After a seller has accepted your offer and you’ve made your earnest money deposit you might hear your Realtor say, “Congratulations, we’re in escrow!”  

Escrow accounts refer to funds held by your bank (also known as mortgage servicer) on your behalf. Escrow accounts most commonly include property taxes, homeowner’s insurance and any applicable mortgage insurance. An escrow account is set up at the closing of your loan, and each month a portion of your mortgage payments goes into your escrow account.

As your homeowner insurance renews or your property taxes come due, the mortgage servicer pays the insurance company and county tax assessor from the funds they are holding in your escrow account.

In the section below we get into the benefits and nitty gritty of escrow accounts.

Escrow & Impound Accounts

Escrow accounts and Impound Accounts are exactly the same thing. There’s no difference between the two and the terms are often used interchangeably. For the sake of clarity, we’ll stick with using the term “escrow account.” Although they aren’t required in all circumstances, escrow accounts can be beneficial to all parties involved when it comes to keeping on top of certain expenses.

There are a few reasons that escrow accounts are advantageous. First and foremost, they protect your lender...

When you purchase a home, anything not funded by you and your down payment is funded by your lender. The lender services your loan with the agreement that you make monthly payments to protect their – and your – investment.

Although your monthly mortgage payment is the main expense to consider, there are taxes and bills that are equally important to maintaining ownership of a home. Property taxes are what you owe on your property and that bill comes due twice a year.

In the event they go unpaid, it could result in a lien or worse, foreclosure. In order for your mortgage lender to have confidence this bill is paid in full and on time, an escrow account is set up that breaks your property tax payments into smaller monthly fees that are included in your mortgage bill.

In this way, you pay your property taxes throughout the year instead of dealing with a single, large bill all at once. This gives your lender an assurance that not only is this crucial bill paid, but it also provides you the same peace of mind.

There are a number of financial obligations that accompany your new home and while many of these expenses need to be tracked and paid regularly, your property taxes only come due biannually. This can easily lead to forgetting about them completely.

It’s not an uncommon occurrence for homeowners, especially new ones, to be caught by surprise when a couple thousand dollar tax bill arrives in the mail. Escrow accounts help you avoid precisely that. Instead of paying a large sum of money once or twice a year, your escrow account divides that payment into monthly installments and saves it as you pay your mortgage.

Escrow accounts are often required for loans with less than a 10% down payment, but otherwise may not be mandatory, though lots of people still elect to have them. To get a better sense of how you should prepare your first home finances, talk to your agent or mortgage advisor about all of your options.

Prepaids

Prepaids, unlike escrow accounts, apply to all loans. They’re items that  must be paid at the time of closing. These payments typically include such items as mortgage interest, real estate taxes,  certain types of insurance, and possibly HOA dues.

Wait a second, that sounds a lot like the escrow account…

...you’re right.

If you’re having an escrow account as part of your mortgage, your prepaids will be collecting the funds needed to jump start your escrow account. In other words, some of your prepaids will go directly into your escrow account to ensure there is enough money there to pay the bills as they come due.

The important thing to understand about prepaid items is that, unlike closing costs, they’re not an inherent part of the home purchasing process, but they are other items that you will pay in a more conventional fashion moving forward.

Let’s recap...

Escrow = The third party company responsible for executing the agreed upon sales contract. Escrow is opened when you have an executed sales contract and an earnest money deposit has been provided to the escrow/title company.

Escrow Account = Funds held by your bank (also known as mortgage servicer) on your behalf to pay homeowners insurance, property taxes and applicable mortgage insurance as it becomes due.

Impound Account = Escrow Account

Prepaids = Funds collected at closing to pay insurance, and property taxes that are due in the near future and/or to also jumpstart your escrow account.

If you have any questions about how the financing of your new home purchase is being allocated, we always recommend you speak with your agent or lender so you feel confident in the process.

In the case of escrow (or impound) accounts and prepaid items, you’ll likely find them to be a very convenient method of meeting your new financial obligations without having to track too many loose expenses, allowing you to simply celebrate your new investment!