Personal Escrow 101: What You Need to Know

Personal Escrow 101: What You Need to Know

If you have a mortgage, you’re likely familiar with the term “escrow.”

Consult Investopedia and you'll see that the official definition for escrow is "a financial instrument held by a third party on behalf of the other two parties in a transaction." Basically, that's a technical way of saying that the money is sitting in a secure account that's owned by neither the buyer nor the seller—rather, it's being watched over by an escrow officer until a deal is finalized.

Escrow is most commonly used when someone is buying or selling a house—having money in escrow means that it's in a holding account, and it hasn't yet been given to the seller. It also figures into mortgage payments, which are often deposited straight into an escrow account for the lender.

RELATED: Mortgages 101

But there's also another version of escrow that people can use to help keep their budgets in check: personal escrow.

What Is Personal Escrow?

Personal escrow follows the same basic principle as escrow that's used in real estate deals: You create a separate account—ideally a high-yield checking or savings account—to hold a certain amount of money, but in the case of personal escrow, you don't employ a third party to monitor it. Like any account, you can set up automatic deposits. And if you opt for a savings account, the money will earn interest. Just note that, while we use the term "personal escrow," the account you set up isn't legally an escrow account—it's simply a checking or savings account, with a specific purpose.

Personal escrow accounts are most commonly used for the following:

Non-Monthly Payments. We all have bills that need to be paid on a recurring basis, but instead of paying some of them monthly, we may receive annual, semi-annual or quarterly bills for things like insurance premiums and tuition bills—which can make monthly budgeting tricky. Translation: If you aren’t anticipating such non-monthly payments properly, they can really throw off your spending in a given month. So it can be a wise idea to allot a certain amount of money into a personal escrow account that's reserved specifically for paying such recurring, non-monthly expenses. In many cases, you can even set up automatic, non-monthly payments from this account.

Unforeseen Expenses. These are costs that take us by surprise—and that aren't necessarily the kind of expenses that you should pay by dipping into your emergency fund. For instance, your best friend invites you to her destination wedding in Bora Bora. Or you find your dream house—but the down payment is just a little out of your price range. Neither of these are true emergencies—they don't threaten your health or livelihood—but they're certainly unexpected expenses.

RELATED: Your Budget Guideline: The 50/20/30 Rule

How Do I Set Up a Personal Escrow Account?

First, you need to decide which kind of personal escrow account you need. You can start by looking back at your expenses over the past year or two (the LearnVest Money Center can help you with this step) to determine how much you spend on non-monthly expenses, which may include:

  • Car registration
  • Life insurance premiums
  • Auto insurance premiums
  • Utility bills paid quarterly
  • School or tuition expenses
  • Vacations or travel expenses
  • Membership dues and/or professional license fees
  • Conference fees
  • Veterinary expenses
  • Gifts
  • Holiday shopping
  • Car repairs and maintenance

Once you've listed out such non-monthly expenses, determine which ones threw off your budget. Were there any expenses that forced you to dip into your emergency savings to cover them? If so, factor these items into your personal escrow account total, so you can anticipate them for the coming year. Once that's figured out, there are two different ways to structure your account:

A Single Savings Account. If you'd like to keep your personal escrow in one account, you first have to figure out how much total money is needed for irregular and unexpected expenses per year, and then calculate how much you need to contribute to the account per month to reach that goal. You can do this by adding up your non-monthly expenses and dividing that figure by 12.

For example, let’s say you’ve determined that you have the following non-monthly expenses:

  • Travel: $2,400
  • Gifts: $1,000
  • Insurance Premiums: $800
  • Car Repairs: $1,200

Your total non-monthly expenses add up to $5,400 per year. Now divide this number by 12: $450. If you deposit $450 into your personal escrow savings account each month going forward, you should be able to cover these expenses as they arise without disrupting your monthly cash flow.

RELATED: The One-Number Strategy: A New Approach to Budgeting

Multiple Savings Accounts. Another way to set up personal escrow is to have a separate savings account for each non-monthly expense. Many online banks and credit unions will allow you to set up multiple savings accounts with no minimum balance required. (Just make sure that you aren't paying fees—if you are, you might want to switch to a different bank or limit your escrow to one account.) The benefit of this approach is psychological: With this method, you won't be as tempted to rob savings earmarked for “car repairs” to pay for your next vacation.

Of course, everyone's financial situation is different. But that's the beauty of personal escrow: It can help you prepare for the trickiest expenses in your life.

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