In the world of real estate, the inability of a borrower to properly insure their home is not only negligent, but potentially a financial disaster for the lender. This also holds true in the case of missed tax payments on the property, as either one of these situations can lead to the lender's collateral being forfeit or lost. For situations where the borrower’s ability to maintain these two vital responsibilities is in question, an escrow account might be the answer.
Understanding escrow accounts in real estate revolves around understanding the need for these two issues to be covered financially by the lender at all times, and further understanding that an escrow account is simply meant to cover these costs. Most borrowers on a mortgage maintain their own forms of "T&I" or, tax and insurance, separately from the mortgage payments they make to their lender. Only in certain cases, such as federally sponsored mortgages made by the FHA (Federal Housing Administration) or the VA (Veterans Administration) do escrow accounts become required. In these cases an escrow account is seen as a necessity considering the federal backing of the mortgages. The government uses these escrow accounts to ensure payments of tax and insurance, so as to be assured that the home will not fall into delinquent status.
For those that seek to maintain their own escrow accounts in private mortgages, most banks offer escrow accounts with their mortgages, and a lump sum payment of principle, interest, tax and insurance can be made to the bank monthly. Some private mortgage companies and banks also require escrow accounts, and set forth standard tax and insurance amounts based on limits set by the Real Estate Settlement Procedures Act of 1973 (RESPA).
RESPA was enacted to prevent the misuse of escrow accounts by overcharging borrowers. This prevents the lender from obtaining more than the minimum balance requirement set before the origination of the loan. This minimum balance requirement is usually no more than two months of escrow payments, and any amount over this sum is refunded to the borrower. Month to month escrow payments are formulated by simply taking the yearly costs of taxes and insurance and dividing by 12. This calculation is called an escrow analysis, and must be calculated every 12 months.
Escrow analysis occurs yearly and can thus cause issues with shortages when premiums or taxes rise. If, for example, taxes rose by $120 a year immediately following an escrow analysis, the mortgage company would cover the costs and then increase the escrow monthly amount accordingly. The subsequent shortage that was incurred when the full amount of taxes was paid would also have to be covered, and this too would have to be spread over the year of escrow payments.
Escrow accounts can also be used as a way to maintain a third party account to allow for the easy transfer of money between a seller and buyer of a property or house. The escrow account allows for both parties to perform the necessary actions to incur a transfer of property. Closing in escrow insures both parties against anything going awry.
Article source: http://www.appraisalarticles.com/General-Real-Property-Topics/3410-How-Real-Estate-Escrow-Accounts-Work.html