If your property is destroyed by a fire, the lender will have lost his collateral. Also if your taxes are left unpaid, your state can foreclose on your property in order to obtain payment and the lender could lose his collateral. Because of that the lender wants to make sure your insurance premium and property taxes are always paid.

The lender collects your property taxes and your insurance premium in a special account. The money in the account will be used to pay your taxes and insurance premiums when they become due. The amount in this account is based on the estimated amount necessary to pay these obligations each year.

The Real Estate Settlement Procedures Act (RESPA) sets limits on the amounts that a lender may require a borrower to put into an escrow account for purposes of paying taxes, hazard insurance and other charges related to the property. Your lender or servicer will review the amount in the escrow account annually and notify you of a shortage or excess. Any excess of $50 or more must be returned to the borrower.

RESPA does not require lenders to impose an escrow account on borrowers; however, certain government loan programs (for example, FHA and VA loans) or lenders may require escrow accounts as a condition of the loan.

If you have a Conventional Loan and you do not have PMI (Private Mortgage Insurance), you have the option to close your escrow account and make your own tax and insurance payments. If you have a VA or FHA loan, the maintenance of an escrow account was a condition for the funding of your government-insured loan. In this case, the escrow account cannot be waived or altered.

Your escrow account payments may include a "cushion" or an extra amount to ensure that the lender has enough money to make the payments when due. RESPA does not require lenders to maintain a cushion and limits the amount of the cushion to one-sixth of the total amount of items paid out of the account, or approximately two months of escrow payments.