Escrow account are not required by law but many lenders require borrowers to set up mortgage escrow accounts that hold the money needed to cover property-related expenses such as insurance and tax. Escrow accounts can hold surplus funds to accommodate any increases in these costs, but surpluses are capped at the federal level.
If an uninsured home were destroyed by fire or another calamity, then the mortgage would effectively become an unsecured loan, since the collateral for the loan -- the home -- would no longer exist. That's why lenders require borrowers to deposit insurance premiums into an escrow account as a way to ensure that premiums are paid and the insurance policy remains in place. Lenders also require escrow money to cover property tax so that no tax liens are placed on a home. A tax lien would take precedence over the mortgage if the home went into foreclosure, putting the lender at risk financiallly.
Even though federal law doesn't require escrow accounts, the federal Real Estate Settlement Procedures Act requires that lenders who require such accounts must balance the accounts at least once per year and provide statements to the borrowers. During the balancing process, lenders calculate how much money the borrower will need to deposit into the account on a monthly basis to raise enough cash to cover the projected annual tax and insurance costs. If property tax rates increase during the year, the account may have a shortfall, while a cut in taxes would leave excess funds in the account. A change in insurance rates would also throw the account out of balance.
The Real Estate Settlement Procedures Act allows lenders to keep surplus cash in mortgage escrow accounts, but the surplus cannot exceed one-sixth of the estimated annual escrow expenses. If tax and insurance costs are lower than anticipated, the lender may end up with an escrow surplus that exceeds the imposed limit. When this occurs, the lender returns the excess funds to the borrower the next time the account is balanced.
Within the boundaries of the federal law, escrow laws vary from state to state. In some states, lenders are required to hold escrow money in interest-bearing accounts, and borrowers are entitled to the interest that these accounts generate, since the funds in question belong to the borrower until tax and insurance bills are paid. In other states, borrowers have no legal right to any interest that the escrow account generates, and many lenders hold the cash in non-interest-bearing accounts. Limitations on escrow surpluses help to minimize losses that borrowers incur as a result of having funds tied up in escrow accounts.