Typically, when you take out a mortgage, your lender requires you escrow your taxes and insurance. This means that you pay money toward these annual expenses when you make your monthly principal and interest payments. Your lender pays the insurance and property tax once a year on your behalf. If your escrow account contains excess funds then you receive an escrow refund check.
The money in an escrow account belongs to you rather than your lender, but your lender holds the money for you to make sure that you have enough money to cover your property tax and insurance. If you fail to pay these costs, then your lender must either pay the costs or contend with having rival liens placed on your home which would complicate any future foreclosure proceedings.
To prevent lenders from requiring borrowers to keep unnecessarily large sums of money on hand to cover escrow costs, state laws require lenders to balance the escrow account once a year and send you a refund if the account holds excess money.
When you buy a home, your lender has to estimate your annual property tax liability because counties only announce the taxes due toward the end of the year. Generally, lenders base estimates of your first year's property tax on the amount of property tax that the previous owner had to pay. However, many states, such as Florida, have laws that cap annual increases in property tax for existing homeowners, but the tax resets when the home changes hand. Conversely, falling property values could result in a drop in property tax. Therefore, the previous owner's property tax burden may bear no resemblance to your property tax liability. This can lead to an excess or shortage in your escrow account.
Your escrow account also covers the cost of your homeowners insurance and, if applicable, the mortgage insurance on your loan. Federal law requires lenders to drop mortgage insurance once you have paid down your loan sufficiently to have more than 20 percent equity. You may reach that point mid-year, but lenders only reassess your escrow account once a year. Therefore, a surplus could build up in your escrow if you continue to pay for mortgage premium insurance even though you no longer need to. Additionally, your homeowners insurance may rise or fall which can also cause your escrow account to have an excess or an shortage.
Many people like fixed-rate mortgages because of the perception that a fixed-rate loan has a fixed monthly payment. In reality, while your lender can disburse excess escrow funds in the form of a refund check, it can also increase your monthly payment in order to recapture money it paid on your behalf if your escrow account lacked sufficient funds.
Some lenders allow you to self-escrow, in which case your mortgage payment never changes but you still have to contend with fluctuations in taxes and insurance so you cannot ever expect the costs related to your home to stay flat for an extended period of time.