What Is Escrow?

Escrow is a term that comes up frequently in real estate and mortgage transactions, but often, neither buyer nor seller fully understands how it works. Escrow is mandatory inmost home sales, and mortgage lenders typically require borrowers to have escrow accounts to cover property taxes and homeowners insurance.

Understanding how escrow works can help you prepare for the home-buying process. Here we dive into what escrow is, how it works and the different types of escrow accounts.

What Is Escrow?

Escrow is defined as a bond, deed or other document kept in the custody of a third party and taking effect only when a specified condition has been fulfilled. It allows both parties in a real estate contract to use a third party, usually an escrow company, escrow agent or mortgage servicer, to temporarily hold money or property until certain conditions are met. Once both parties meet all terms of their agreement, funds and property are released.

How Does Escrow Work?

Once a property sale agreement is made or a contract is signed, an escrow account is opened.

The buyer deposits funds into this account, which are held within the account until all obligations, like home inspections or financing approvals, are met. If all goes well and the deal progresses past all contingencies, the funds are released to the seller typically at closing or funding. If not, funds may be returned to the buyer.

Typically, the seller's agent will open an escrow account with a local escrow company on behalf of the seller once the listing is agreed to in writing. Many states allow the buyer to choose what company handles the escrow, so sometimes, even if the seller already has an escrow opened with one company, the buyer can elect to have anew escrow opened with the company of their choice. This varies state by state and in some cases, county by county. Some states and counties allow for title and escrow to be one company, while others require them to be separate companies.

Different Types of Escrow Accounts

For the purposes of the real estate transaction, there are two different types of escrow accounts — one during the buying process and another used after purchasing a home.

Escrow During the Home-Buying Process

Escrow holds property and all funds involved in the transaction, including the down payment, closing costs and earnest money, until all conditions of the sale are met.

When making an offer on a house, many buyers offer earnest money, also known as a good faith deposit, to represent their intent to make a purchase. Earnest money protects the seller if the buyer backs out, and if the transaction goes through, then the earnest money goes toward the buyer’s closing costs or down payment.

To protect the buyer and seller, this money is kept in an escrow account until closing. It is usually managed by the escrow agent or title company handling the mortgage transaction. If the seller cannot stick to the contract terms, then the earnest money in the escrow account goes back to the buyer, and the buyer is released from the contract.

Escrow for Paying Taxes and Insurance

While escrow is used during the home-buying process to protect all parties in the transaction, an escrow account is also used to hold the homeowner’s funds for property taxe sand homeowners insurance throughout the life of the mortgage.

To minimize the risk of defaulting on the loan or incurring liens on the property, lenders want to make sure you pay your homeowners insurance and property taxes on time. Lenders divide this bill into 12 equal payments and collect this money as part of your monthly mortgage payment. Your lender will manage these funds to pay property taxes and insurance on your behalf.

If you aren’t required to have a mortgage escrow account, you’ll need to pay these bills on your own. These are typically large bills that homeowners must pay once or twice a year. If you fail to pay your property taxes, your state or local government could charge fines and penalties or place a tax lien on your home. Eventually, the county could pursue foreclosure.

Benefits of Having an Escrow Account

Having an escrow account protects every party in a real estate transaction. It also helps ensure homeowners pay insurance and tax bills on time.

Peace of mind for all parties is the biggest benefit. Having a neutral third party to hold onto the important documents and all the money allows you to know that as long as you do your part and the other party does theirs, things will go as expected.

Without having an escrow account and a neutral third party, the homebuyer and the seller would have to simply rely on each other to follow through, and that is dangerous when it comes to transactions the size of a home purchase.

For homeowners, an escrow account can alleviate the stress of coming up with a large payment to cover taxes and insurance. It may also simplify budgeting for homeowners, spreading out large annual expenses into smaller monthly payments.

All in all, escrow doesn’t need to be a scary word, even if you don’t know what it means going into your first home purchase. Escrow accounts are there to provide peace of mind and help you manage your home expenses. If you have any further questions about escrow, a Fairway loan officer can help!

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