Escrow: What Is It and How Does It Work?
Escrow is a key part of real estate transactions and mortgage agreements, but many homebuyers and homeowners aren’t familiar with escrow and how it works. Escrow protects homebuyers, sellers, homeowners, and even lenders with real estate-related financing—it supports those parties throughout the homeownership lifecycle.
Let’s break down what escrow is, its role in real estate, and how it can be beneficial.
What Escrow Really Is
Escrow is an account where funds are held by a third-party provider, such as a title company or real estate attorney, until both sides have met the contract terms. When the two parties have upheld their end of the agreement, the escrow provider will release the money or assets in the account to the necessary parties.
Escrow can be used in any transaction and is usually used for larger purchases, such as car purchases. It’s most commonly used in a real estate transaction.
How Escrow Actually Works
In a home-buying transaction, the escrow holds funds until the buyer and seller meet the purchase agreement terms and close the deal. Buyers and their mortgage company must transfer the agreed-upon funds into the account, and the sellers must prove the home is in acceptable condition (via an appraisal, inspection, and/or buyer walk-through) before the deal goes through. Once the escrow provider confirms the contract conditions are met, each party receives its portion of the exchange.
Escrow also protects buyers and sellers throughout the process in case of a dispute. The escrow provider acts as a mediator in the event of an issue, and the money is held in a separate account from the buyer or seller, so it can’t be withheld for reasons not outlined in the agreement.
Most homeowners also have escrow accounts for insurance and taxes, according to the terms of their mortgage. This type of escrow works by homeowners paying a monthly sum included with the mortgage payment to be set aside in an escrow account. The lender can then use the account to cover tax and insurance payments on the home.
What Is an Escrow Account?
An escrow account is a bank account where funds are held and managed by a third party until the terms of a contract are upheld. There are two different uses for escrow accounts in real estate—one to hold funds during the home-buying process and the other for homeowners to set aside funds for insurance and property taxes.
Home Buying Escrow Accounts
Homeowners might first become acquainted with escrow accounts during the home-buying process. When putting in an offer, a buyer usually provides an upfront payment, called earnest money, to show the seller their commitment to the deal. This money is held in an escrow account until closing. As the deal progresses, buyers will add their remaining down payment, closing costs, and funds from the lender into that account. When the deal closes, those funds are distributed to the sellers and other parties needed to be paid, such as the title company or a real estate agent.
Escrow protects both parties during the transaction. For example, if the buyer decides to back out of the deal, the seller will still receive the earnest money held in the escrow account. If the seller backs out or doesn’t meet the purchase agreement terms, the buyers will receive the earnest money back and walk away from the deal.
Because a third party handles the escrow account, buyers or sellers may also need to pay escrow fees to compensate an agent or company for the paperwork and transaction fees. This cost is usually 1-2% of the home’s purchase price and is included in the closing costs.
For Taxes and Insurance: When to Use Escrow
If you purchased your property with a mortgage loan, your lender will likely set you up with an escrow account to pay for insurance and taxes. As you pay your monthly mortgage, a portion of the payments will be set aside in the escrow account for the lender to pay for your homeowners insurance and tax bills.
Lenders estimate the total amount for insurance and taxes based on the previous year’s amounts. Since those bills can fluctuate from year to year, you may have over or underpaid those bills in your mortgage payments.
The mortgage company must monitor the bill costs to ensure it’s charging you the correct amount. If homeowners have overpaid into the escrow account, the lender will issue an escrow refund. If the lender collects too little, it will notify you that you have an escrow shortage. You’ll need to cover the difference with a one-time payment, or the amount will be divided by 12 and added to your monthly payments.
Who Manages an Escrow Account?
Escrow accounts are helpful in real estate because an unbiased third party manages them.
The escrow provider, either an escrow agent, escrow company, or mortgage servicer, can help settle any disputes between contracted parties and keep the process fair according to the terms of the agreement.
An escrow agent or escrow company typically handles accounts during the home buying process, and a mortgage servicer manages escrow accounts throughout the lifetime of the mortgage loan.
Differences Between an Escrow Company and Escrow Agent
An escrow agent is an individual, a real estate attorney, or someone affiliated with the title company. An escrow company has the same responsibilities as an agent. Escrow agents and companies support buyers and sellers in the home buying process to ensure paperwork is correct and both parties follow the purchase agreement’s terms.
What Is a Mortgage Servicer?
A mortgage servicer is a company that manages the tasks and logistics of a mortgage, including sending borrowers monthly mortgage statements. While the mortgage servicer handles mortgage logistics, including managing the homeowner’s escrow account, it may or may not be the same company that provided borrowers with the loan.
How an Escrow Account Benefits You
Escrow has its benefits for multiple parties. Here are a few reasons you might want to use escrow as a home buyer, homeowner, or mortgage lender.
Home buyers benefits
As a buyer, an escrow account protects you by safeguarding your earnest money until the seller proves they have met all the purchase agreement terms and are leaving the property in acceptable condition. If the sellers don’t hold up their end of the deal, buyers can recoup the earnest money in the escrow account.
Escrow can be beneficial to homeowners as well. When homeowners pay into escrow with their monthly mortgage payments, they only pay 1/12 of the total property taxes and insurance bills. This spreads out the money a homeowner is responsible for and avoids larger bills due at once. Additionally, homeowners can avoid late payments or late fees since the mortgage company is responsible for using escrow funds to pay the bills on time.
Escrow benefits lenders by ensuring borrowers pay their homeowners insurance and property taxes in full and on time. An escrow account also reduces the risk of a lien against the property.
It can be confusing to understand how escrow works. Here are quick answers to some of the most common questions people have about escrow accounts:
How long do you pay escrow for?
Homeowners pay escrow as long as they have a mortgage on the property. Homeowners can suspend paying escrow once the principal is paid off, and they can take responsibility for paying their property taxes and insurance payments.
Is escrow a good thing or a bad thing?
Escrow is neither good nor bad for homeowners. It’s all a matter of preference. If homeowners choose not to have an escrow account, they are responsible for paying taxes and insurance bills independently. Many prefer having all the expenses on one bill (mortgage payment) and choose to use an escrow account to hold the funds from the payment needed for taxes and insurance.
For buyers and sellers, escrow is usually a good thing. It protects the buyers’ money and ensures the sellers have held up their end of the purchase agreement. It also protects the sellers if buyers withdraw from the purchase for reasons not outlined in the agreement.
What is escrow on your house?
Escrow on the house typically refers to the escrow payments homeowners make to pay for their tax and insurance bills. The escrow payments are a portion of a homeowner’s monthly mortgage, and the funds are held in an escrow account until the mortgage company withdraws the money to pay for those bills in full. Once homeowners pay off the loan, the mortgage escrow account is no longer needed, and homeowners will be responsible for paying for insurance and taxes on their own.
What is your escrow balance?
The escrow balance is the amount of money homeowners have sitting in the escrow account. This money comes from the escrow amount homeowners pay as part of their monthly mortgage payments. Mortgage companies use the escrow balance to pay the yearly homeowners insurance and property taxes.
Do you even need an escrow account?
If buyers purchase their home without a mortgage, an escrow account isn’t needed for taxes and insurance since they don’t have a lender to make the payments on their behalf. For homeowners with a mortgage, the lender may or may not require escrow.
Typically, lenders require buyers to have an escrow account if they put down a down payment of less than 20% of the home’s purchase price, but some mortgage lenders give homeowners a choice. For example, FHA loans and USDA loans require escrow accounts. VA loans do not require them.
What does it really mean to be “in escrow?”
The term “in escrow” means an asset (usually money) is being held until the conditions of the agreement have been met by both parties. This period in real estate is often 30-60 days, or however long it takes for the deal to close.
How does escrow apply to real estate?
Escrow comes up multiple times in real estate when two parties need a neutral location to hold money or other assets until contract conditions (like a purchase agreement) are complete. It is also often used by homeowners with a mortgage to hold funds for tax or insurance bills that the lender pays on their behalf.
What are the different scenarios where you can use escrow?
There are two common scenarios where escrow is used in real estate. The first is in the pre-closing period, when buyers submit funds to an escrow account, and the funds are held from the sellers until the property is deemed acceptable and available to the buyers.
The second use of escrow in real estate is mortgage escrow, where homeowners pay a set amount as part of their monthly mortgage payment into an escrow account for the lender to pay the insurance premiums and property taxes.
In addition to using escrow with real estate, escrow accounts can also be used in the following situations:
- Rent payments: Renters may be able to pay rent into an escrow account, ensuring renters get their money back if a landlord isn’t maintaining the property according to the lease agreement.
- Large transactions: Escrow accounts can be useful for other large transactions, such as a car, to give you a stronger sense of security. You can contact an escrow agent if you’d like to incorporate escrow into your transaction, or there is sometimes an option to use escrow with online purchases.
- Stock: For employees who are compensated through stock, those shares are often held in an escrow account until a set waiting period has passed and employees can sell the stock.
What is an escrow waiver, and when should you get one?
An escrow waiver is an exemption that allows a homeowner to forgo an escrow account with their lender and cover the taxes and insurance payments themselves. If your lender requires you to have an escrow account and you would prefer not to have one, you can ask your lender if you can apply for an escrow waiver.
Some homeowners prefer to handle insurance and tax bills and get an escrow waiver to control the payments. If you obtain an escrow waiver, remember that instead of spreading out property taxes and insurance payments over 12 months, you will be responsible for the total cost of each item as they’re due. Take note of when those bills are due, and be sure to have the total amount ready on the billing date to avoid late fees.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.