When you purchase a home, your mortgage lender requires a portion of your monthly mortgage payment to be placed into an escrow account. This money is used to cover your annual property taxes and insurance premiums.

If your house was destroyed by fire and you hadn’t paid your insurance premium, then your lender would lose their collateral. The same goes for your property taxes. If you don’t pay your taxes, your state can foreclose on your property and your lender loses their collateral. Therefore, your lender wants to make sure your insurance premiums and property taxes are always paid.

The lender establishes an escrow account to hold the funds until your payments are due. This way they can make sure your taxes and insurance premiums are paid on time. The amount held in this account is based on the estimated amount needed to pay your taxes and insurance premiums each year. Your lender may overestimate the amount needed to ensure they have additional funds to cover any changes in your taxes or insurance premiums when the payments are due.

The Real Estate Settlement Procedures Act (RESPA), however, limits how much money lenders can require that you put into an escrow account. Generally, it is a maximum of two months’ worth of escrow payments. Annually, your lender will review the amount of money held in your escrow account, and notify you if you have a shortage or overage. If you have over $50 in excess in your account, your lender must return the money to you.

Your lender usually decides whether you’re required to have an escrow account or not. However, the Federal Housing Administration (FHA) requires lenders to establish an escrow account for FHA-backed loans. The Veterans Administration (VA) doesn’t require escrow accounts on VA-guaranteed mortgages, but most lenders will set up an escrow account on a VA loan. For conventional mortgage loans, the borrower may not have to have an escrow account, depending upon lender requirements, but most borrowers prefer to maintain escrow accounts as a budgeting device to save the necessary funds for tax and insurance payments.

If you’re considering purchasing a home, contact a trusted mortgage broker to help you determine what type of mortgage is right for you. A mortgage broker can also give you an estimate of how much you’ll need to put into an escrow account to pay your insurance premiums and property taxes.