What Is Escrow and How Does It Work?

Escrow is a legally binding arrangement where a third party holds assets from a buyer and seller during the sales process until a transaction is complete. While escrow can be used for various purposes, from online purchases to home buying, the most common use is to ensure fair real estate agreements. The escrow company or agent is a third party who has no conflict of interest, ensuring a fair and smooth agreement. Here, we’ll go over escrow, how it works, the different types, and the pros and cons.

How Does Escrow Work?

In an agreement to purchase goods or services, there are two parties: a buyer and a seller. Each party has certain requirements, including payment for the asset and providing the asset as it was described throughout the sales process. However, in high-stakes financial transactions, there is often more at play.

A buyer wants to ensure that the asset being purchased is the quality they expect and the seller wants to ensure that payment for the asset, once the value is proven, is received in a timely manner. If it is not, they want the ability to sell to other potential buyers.

To protect both of these parties and ensure fair deals, an escrow provider is brought in as a middleman to hold assets until both parties have met their sides of the agreement. In the sale of a home, the provider will hold the cash from the buyer and property documents from the seller.

Once the agreement has been reached, the escrow provider will distribute assets according to the agreement and close the escrow account. This process protects the buyer and the seller who would otherwise be at risk for one party falling through on their end of the deal.

Types of Escrow Accounts

As previously mentioned, escrow accounts can be used in a variety of settings but are most commonly used in real estate. In real estate, there are two types of escrow accounts used: one in the home buying process and one after the sale has closed and the buyer owns the property.

1. Home Buying Escrow Account: To protect the buyer from hidden property damages and the seller from uncommitted buyers
2. Homeowner Escrow Account: To ensure annual property taxes and homeowners’ insurance payments are made, in a convenient monthly format bundled with a homeowner’s mortgage payment.

Home Buying Escrow Accounts

In the process of purchasing a home, there is typically a requirement for a good-faith payment, called earnest money, to show the seller you are seriously considering the purchase of their property. The amount of an earnest payment varies but is often 1 to 3 percent of the value of the property.

Here’s where escrow comes in. An escrow account will be set up to hold this good-faith payment, in addition to the property deed, and ensure the owners are given to the entitled party throughout the process.

In the case that a contract falls through at the fault of the buyer, the seller will typically be given the earnest money. If there’s an issue with the property that wasn’t disclosed or known of before the sale of the property, such as a bad roof or poor infrastructure found during the inspection, the buyer can get the earnest money back if the issues aren’t solved.

If everything goes as planned in the agreement, the money will be put toward the buyer’s down payment.

Homeowner Escrow Accounts

After the sale is closed and the buyer owns the property, the mortgage lender could open an escrow account to pay for the homeowners’ property taxes and insurance. This account is funded through a homeowners’ monthly mortgage payments made to the lender. Once received, the lender or mortgage servicer will take a chunk of that mortgage payment and put it in the escrow account to pay for tax and insurance payments. Property taxes are paid three to four times a year, and insurance is usually paid annually.

In this scenario, a breakdown of the monthly mortgage payment would include the following elements, often referred to as “PITI.”

Since tax amounts and insurance premiums can vary each year, the mortgage servicer will estimate the escrow payments added to the monthly mortgage a year out, based on the amount from the previous year. As an escrow account is a form of insurance to the lender that you will pay your bills, a servicer may also require that there is an extra two months worth of payment in the escrow.

Each year, a servicer will take a look at the escrow account and make sure there isn’t a surplus or deficit of funds needed. In the case of a surplus, they will distribute a refund to the homeowner. In the less likely case of a deficit, the homeowner will need to pay what is still needed to make the payment. Typically, a homeowner can satisfy this through a lump sum payment or an increase in the amount of their monthly mortgage payment that funds the escrow account.

Throughout this process, if a homeowner would like to take money out of their escrow account, they will have to follow the processes laid out by the servicer, though disbursements often only happen when a lender changes or the property is sold. Usually, if a homeowner is selling a home, the servicer will refund any funds in the escrow account within 30 days after the sale of the property.

Pros and Cons of Escrow Accounts

There are several pros and cons to utilizing escrow accounts in the purchase of a new home and paying taxes and homeowners’ insurance.

Pros

The purpose of escrow is to protect the seller and the buyer, as well as the lender in a mortgage agreement.

• If there’s an issue found during an inspection of the home and the sale falls through, the buyer will receive their earnest payment back in line with the agreement.
• Homeowners can pay their mortgage, property taxes, and homeowners’ insurance to one party (their lender or mortgage provider) in monthly payments rather than having to come up with large payments annually.
• By collecting money from the homeowner monthly, lenders and mortgage providers can ensure that annual property taxes and homeowners’ insurance are paid on time so the property isn’t put in jeopardy.

Cons

The cons of escrow primarily fall on the homeowner in the agreement.

• A homeowner will have higher monthly mortgage payments since homeowners’ insurance and property taxes are included to fund your escrow account.
• The dollar amount needed for the escrow account may vary after the close of the property sale depending on property tax and homeowners’ insurance costs. This could result in a refund to the homeowner or more money needed from them to make the payment.
• The monthly mortgage payment could change each year. If a homeowner frequently owes money due to higher tax and insurance costs, a lender or mortgage provider will raise the monthly payment to avoid out of pocket expenses moving forward. If a homeowner frequently has excess in their account, the servicer will either lower the monthly mortgage payment or keep it the same to provide a cushion for any future changes.

Do You Have to Have an Escrow Account?

You may not always have to use an escrow account to pay for property taxes and insurance. If you choose to do so yourself, you will have lower monthly mortgage payments, but you will be responsible for coming up with large payments by the annual due dates, which can be thousands of dollars.

In some cases, however, you may not be able to avoid an escrow account. Many lenders now require an escrow account to take out a mortgage to lower their lending risks. In other cases, you may need to have a significant down payment to opt out of an escrow account. They can also incentivize the borrower to use the escrow by lowering the interest rate.

How Do You Get an Escrow Account?

Your real estate agent or lender may recommend a service provider to handle your purchase escrow account, but you should ensure they are reliable. Your best bet is going for a well-known escrow company that has positive reviews online.

Escrow is a valuable service that protects all parties in the process of buying a home. It ensures the buyer receives a fair deal, the seller gets their payment, a homeowner has no outstanding tax or insurance payments and that the mortgage provider gets their money back.

While an escrow account may not be required in all cases, it can be a good decision for the large financial investment of buying or selling a home. Most of the time, you don’t know who the buyer or seller is in the real estate market. To give yourself peace of mind, an escrow account can serve as insurance during the process. In no time, the house you want to buy can be yours, or the house you want to sell can be in good hands. If you want to learn more about the home buying process do’s and don’ts, make sure you check out Mint for expert financial advice.