When you have a mortgage with an escrow account (for property taxes and home owner’s insurance), the lender requires you to make a monthly mortgage payment that includes principle, interest, one twelfth of your annual property tax bill, and approximately half of your annual homeowner’s insurance premium. In other words, you pay your insurance and taxes to the lender, and the lender pays those bills for you when they are due.
Lenders pay your homeowner’s insurance when the premium is due; therefore, they want to make sure that the policy is always current and that there will be enough money in the escrow account to pay the insurance on time. The same is true for property taxes. But if you are refinancing and they have not had the benefit of collecting your taxes all year long, you will need to “fund” your escrow account with enough money at the time of the refinance so that the lender can pay the full amount when the tax bill is due.
The same scenario applies when you are purchasing a home. For example, if the taxes are due in three months and the lender has to pay your full tax bill in three months, the lender will only have three payments by that time. The lender will then require you to fund the escrow account with the remaining nine months at the time of closing.
Escrows are sometimes required and sometimes they are not. Whether they are can depend on how much you put down on the loan at the purchase or how much equity you have in the home. Usually if you put down less than 20% at the time of purchase or have less than 20% equity in the property you will be required to have an escrow account. But one thing is for sure: if you do have an escrow account, the lender will usually collect enough to cover your taxes and your insurance plus an additional three months in reserve, as a cushion, in case your insurance or your taxes go up during the year. Remember also that funding your escrow account is not considered a closing cost --closing costs are the fees associated with generating the loan. You have to pay for tax and insurance regardless of the mortgage.