What Is an Escrow Account and How Does It Work?

How Mortgage Escrow Accounts Work

An escrow account — sometimes called an impound account — is a holding account managed by your mortgage servicer that collects and disburses funds for your property taxes and homeowners insurance. Instead of paying these large annual or semi-annual bills directly, you make a monthly deposit into escrow as part of your regular mortgage payment. When your tax bill and insurance renewal come due, the servicer pays them on your behalf from the accumulated funds.

The escrow portion of your payment is entirely separate from principal and interest. Principal and interest reduce your loan balance and pay the lender’s interest income. Escrow is a pass-through — the money is collected, held temporarily, and disbursed to the tax authority and insurer. The balance in your escrow account is your money, not the lender’s. When you pay off your loan or sell your home, the servicer returns the escrow balance to you.

How the Monthly Escrow Amount Is Calculated

Your servicer divides your estimated annual property tax and insurance costs by 12 to determine the monthly deposit. RESPA (Real Estate Settlement Procedures Act, Section 10) allows servicers to maintain a cushion of up to two months of escrow payments to cover unexpected increases or timing variations. The servicer cannot require more than this two-month cushion at any time.

Texas-specific calculation: $400,000 home, 2.0% property tax rate, $3,400/year insurance. Annual taxes: $8,000. Annual insurance: $3,400. Total annual escrow obligation: $11,400. Monthly deposit: $950. Two-month cushion: $1,900. At closing, the lender collects the initial months needed to fund the account plus the cushion — typically $2,850–$5,700 total depending on when the next tax payment is due. Texas property taxes are billed in October and due January 31, so the amount collected at closing depends heavily on whether you’re closing in January (close to the next due date) or September (just after the prior payment).

Annual Escrow Analysis and Adjustments

RESPA requires servicers to conduct an annual escrow analysis comparing what was collected to actual disbursements. If your actual tax or insurance costs exceeded projections, you have a shortage — the servicer can either require a one-time catch-up payment or spread the difference over the next 12 months of payments (adding to your monthly escrow deposit). If actual costs were lower than projected, you receive a refund of the overage.

Texas-specific escrow timing: Texas property taxes are billed in October and due January 31 of the following year. Escrow servicers must have sufficient funds accumulated by January to make the payment. Your first year of ownership will likely show an escrow “shortage” in the annual analysis because the lender estimates conservatively and the full tax bill may exceed initial projections. This is normal. Plan for a year-two escrow adjustment that may increase your monthly payment slightly or result in a modest catch-up.

Texas homestead exemption and escrow: when you file your homestead exemption (reducing school district taxable value by $100,000) in the spring following your purchase, the exemption takes effect January 1 of the following year. Your servicer’s escrow estimate before the exemption activates uses the full pre-exemption tax bill. After the exemption takes effect, the annual analysis recognizes the lower actual tax bill and typically produces either a refund check or a reduction in your monthly escrow deposit — usually $67–$100/month less in escrow starting in year two.

When Escrow Is Required

Escrow is mandatory on all FHA loans (for the life of the loan regardless of LTV), all VA loans, all USDA loans, and conventional loans with less than 20% down. For conventional loans with 20%+ down, borrowers may have the option to waive escrow — meaning they manage property taxes and insurance payments directly. Some lenders charge a fee for the escrow waiver (typically 0.125–0.25% of the loan amount upfront, or a slightly higher rate). For Texas homeowners with high property taxes, the escrow system provides important protection against missed tax payments — a delinquent Texas property tax creates a senior lien that supersedes your mortgage, which lenders take very seriously.

If you currently waive escrow and want to set it up, contact your servicer. If you want to waive escrow on a new purchase with 20% down, confirm the lender’s policy and any associated fee before deciding — for some Texas buyers with irregular income, paying one large semi-annual tax bill is harder to manage than including it in monthly escrow. For others, the discipline of accumulating tax funds monthly in their own high-yield savings account at market interest rates is preferable to earning no interest on servicer-held escrow funds. Both approaches are valid depending on your financial organization style.

Escrow Account for New Construction

Newly constructed Texas homes have a first-year escrow complication: your initial assessed value for property tax purposes may be significantly below market value. Many Texas counties assess new construction at land value only for the first partial year, with a full assessment in the following year. Your servicer will establish escrow based on the available tax information at closing, which may dramatically understate the future tax bill. Buyers purchasing new construction in Texas should get an estimate of their expected first full-year property tax bill from their real estate agent or the county appraisal district and compare it to their escrow setup amount. An escrow shortage in year one is very common on new construction and can result in a catch-up payment request of $1,500–$3,000 if the initial estimate was based on partial-year land-only values.