Escrow accounts, or for those in California, impound accounts, are established by the borrower when first obtaining a new mortgage loan. Each month, when a borrower makes a mortgage payment, it includes mortgage interest, mortgage principal and two other items: Property taxes and hazard insurance.

For states where taxes are paid annually, each mortgage payment will include 1/12th of the owner's annual tax assessment. When it comes time to pay the property taxes, the lender pays such taxes when due. Likewise, when hazard insurance premiums are up for their annual renewal, money paid into the escrow will be used to pay for another year's coverage. With escrow, the homeowner never has to wonder if their property taxes are paid or if their hazard insurance is in force. Escrow accounts take care of that for them.

But why have escrow accounts in the first place? Why can't owners just pay their own property taxes and hazard insurance?

From an actuarial standpoint, loans with escrow are believed less likely to default than loans without them. At years end, tax defaults won't occur if payments have been adding up in a lender's account.

Most homes bought with less than 20 percent equity require the establishment of an escrow account as a condition of the loan. If you can place a bigger down payment on the property, perhaps because you're moving up to a replacement home and have cash from the sale of your current residence, then establishing an escrow account is usually an option.

But even with more than 20 percent down, lenders are so convinced that escrow accounts are good for you (and them) that they may pay you to set one up. On the West Coast, for example, it's not uncommon for lenders to offer consumers a bonus equal to 1/4 percent of their loan amount if they decide to establish an escrow account. In other parts of the country, lenders may take the opposite approach and make you pay extra if you DON'T set-up an escrow account. Either way, lenders like them.

What does it take to establish an escrow account? Federal rules allow no more than two months' plus $50 at loan closing for a new purchase. This money -- which is kept in the account in addition to the monthly payments made by borrowers -- is used to establish the account and is there in case there is a shortage at years' end. This can happen because during the course of a tax year your local government may be hard at work changing the tax rates or your school taxes might increase. In such cases, those regular payments you've been making with each monthly mortgage bill may not be enough to pay for local taxes and insurance coverage. The two months' escrow account acts as a "cushion" to soften the blow of higher-than-anticipated annual tax bills come due.