Most lenders on conventional, FHA and VA loans require that the borrower establish an escrow account out of which property taxes, homeowners insurance and mortgage insurance are paid. An escrow account (sometimes called an impound account) is a separate account which the lender administers on behalf of the borrower to collect and pay for taxes and insurance, and if so required, private mortgage insurance (PMI).
The purpose of the escrow account is for the lender to assure itself that the taxes and insurance on the property are paid. The escrow account is usually set up at closing. The lender (or the closing attorney) obtains or estimates the annual amounts for property taxes and homeowners insurance on the property. These amounts are then divided by 12 to equal a monthly amount. The monthly amounts fro taxes and insurance (and PMI, if required) are placed in a separate account. Additionally, at closing the lender will collect certain amounts up front which are deposited into the escrow account. Typically, the lender collects 2 to 3 months of homeowners insurance and several months of property taxes, which are the initial deposits into the escrow.
The amounts collected at closing, together with the monthly payments, provide the lender with enough money in the account to pay the taxes and insurance as they become due. The lender is also allowed to keep a reserve of up to 2 months of taxes and insurance in the account in case there is an increase in the taxes or insurance.
The lender can keep any interest earned on the escrow balance to cover its administrative costs. Lenders are required to analyze the account at least annually and refund to the borrower any surplus. Finally, lenders will occasionally waive the escrow account if the borrower makes a down payment of 20% or more, but may charge a fee to the borrower to do so.