Many mortgage payments include more than principal and interest. A portion is collected for property taxes and insurance, held by the servicer, and paid out when those bills fall due.
Why the lender wants control of these payments
Unpaid property taxes can create a claim on the property that ranks ahead of the mortgage, which would place the lender behind a third party in a forced sale.
A lapsed insurance policy is equally damaging, since the building securing the loan could be destroyed with no compensation available to cover the outstanding balance.
Collecting monthly and paying the bills directly removes both risks entirely, which is why the arrangement is commonly required rather than offered as a convenience.
How the monthly amount is set
The servicer estimates the annual cost of taxes and insurance, divides it across twelve months, and adds a cushion so the account does not run empty before a large bill.
The estimate is based on the most recent known figures, so it lags reality whenever an assessment is revised or a policy is renewed at a different premium.
Because the estimate is made once a year, the monthly payment can be correct for eleven months and then prove to have been too low all along.
Why annual analysis produces surprises
Servicers review the account periodically, compare what was collected against what was paid, and adjust the monthly figure for the coming year.
A shortfall must be recovered, usually either as a lump sum or spread across the next twelve months on top of an already increased monthly amount.
This is why a mortgage payment can rise sharply on a fixed-rate loan. The interest rate has not changed; the amount required for taxes and insurance has.
Where the money sits in the meantime
The funds are held separately from the lender's own money and can only be used for the specified purposes, which is what distinguishes the arrangement from a deposit.
Whether interest is paid on the balance varies by jurisdiction, and many require it while many do not, which is a meaningful difference on a balance held for years.
Limits on the size of the cushion are also commonly set by rule, since without them a servicer could hold considerably more of a borrower's money than the bills require.
What waiving the arrangement involves
Some lenders will waive it where the loan-to-value is low, sometimes for a fee, leaving the borrower to pay the bills directly.
The borrower then holds the money themselves and must have it available when the bills arrive, which suits disciplined savers and exposes everyone else.
Rules on when a waiver is permitted, how balances are treated and what disclosure is required vary by country and change, so the local position governs.