Technically speaking, escrow is something of value, such as documents, property or money, held in trust and released upon satisfactory completion of the terms of a contract. Insurance escrow is the application of this concept to real estate. Required by most mortgage lenders, the amount due for the annual payment of hazard insurance premiums is accumulated monthly on a pro-rated basis. In the United States and many other countries, insurance escrow contributions by a borrower are maintained in special accounts established by the lender and paid out to the insurance company when due.
Most such escrow accounts, in fact, also include the amounts due for property taxes, which can be significantly larger than insurance premiums. These payments are also pro-rated and accumulated in the escrow account on a monthly basis.
Mortgage lenders generally establish insurance escrow accounts to protect their investments. If either insurance or property tax payments aren't made when due, significant problems could result, jeopardizing the lender's investment. For example, if insurance premiums aren't paid when due and a hazard such as a fire occurs, the resulting loss won't be covered, and the loan's collateral — the property itself — might lose so much of its value that the proceeds of a foreclosure sale, if necessary, wouldn't be sufficient to satisfy the balance due on the loan. Likewise, when property taxes are left unpaid for a certain period of time, the taxing jurisdiction can recover the taxes due by putting the property up for sale at a tax auction. Although a homeowner can regain clear title to property sold at a tax auction through the redemption process, mortgage lenders generally prefer not to have to deal with any encumbrances on the titles of property used as collateral.
While the establishment of insurance escrow accounts provides a great benefit for mortgage lenders because they help to keep property titles clear, homeowners themselves also benefit. In many cases, the payment of an annual insurance premium or quarterly tax bill can place a great strain on a borrower's budget because of the size of the payments due, especially if both payments are due around the same time. Lender-required insurance escrow accounts guarantee that the funds necessary to pay insurance premiums and property taxes will be available when due. In addition, since the payments made by the borrower are pro-rated, the monthly contributions by homeowners to escrow accounts usually don't put such a great strain on the borrower's finances.
From a borrower's perspective, there are also some drawbacks to insurance escrow accounts. In many cases, when mortgages are transferred from one lender to another, a common occurrence in the United States, errors are made in the calculation of the escrow amount and the history of payments made therefrom. This imposes on the borrower the responsibility of carefully monitoring the insurance escrow account, especially after such transfers. Another problem is that lenders themselves sometimes don't make insurance premium or tax payments when due. Such errors usually generate a round of telephone calls and correspondence, although reputable lenders, when such problems are called to their attention, generally pay such amounts immediately and reimburse the borrower for any costs incurred by virtue of the late payment.
Finally, insurance escrow accounts on residential properties usually aren't interest-bearing, meaning that the borrower who makes monthly contributions to such an account is foregoing interest income on those funds.