Home buying has its own set of jargon, and it can be a bit overwhelming. One term that often confuses buyers is “escrow.” Fortunately, it’s a pretty simple concept to understand.
What is Escrow?
In short, an escrow account acts as a middle-man between two individuals or groups who want to trade assets. The account holds onto the property that is being traded to ensure that both parties are invested, and no one is at a higher risk of loss than another.
Think of it like this. You and another person want to make a trade (in this case, money and a house), but you don’t know or necessarily trust the other person. So, you both hand over the goods to a person or company you do trust (in this case, a bank), and that third-party makes the transaction happen when all goods are in hand.
While commonly associated with buying a home, an escrow account is not only reserved for real estate transactions. Big businesses use this type of account during major trades and purchases to protect both party’s interests.
Escrow begins with a signed contract (and deposit of required property) and ends when both parties have fulfilled their part of the agreement.
Escrow and Real Estate Sales
During the home-buying process, you’ll likely have to deal with escrow twice. The first instance happens when you find the home you love and decide you want to make an offer. If your offer is accepted, your agent will ask you to provide “earnest money.”
Earnest money: This term refers to money used to confirm a contract. Your earnest money acts as a sort of collateral on the purchase.
The amount of money you must front usually ranges between $500 and $1,000. Though if you are living in a hot market, you might be asked to pay more cash to secure your offer, as much as 2 to 3% of the total purchase, according to the Home Buying Institute.
In most cases, you’ll provide your realtor with a check or money order for the total earnest money amount. The agent might hold onto the check without cashing it or put it into an escrow account.
You could lose your earnest money if you back out of the contract without a good cause or if you fail to meet deadlines set in the offer agreement. You can get your earnest money back if the deal falls through, but some contingencies must be met for that to happen.
If the sale is successful, the money in the escrow account goes toward closing costs or other expenses.
The seller does not put money into an escrow account. However, they have their own responsibilities during the sales process. They must provide access to the property for inspections, make any required repairs, and submit their property title for inspection.
If a title comes back with liens or other items, the buyer can back out of the sale and have their earnest money returned.
Escrow and Home Ownership
The second time you’ll hear about escrow is when you purchase a home. Many homeowners use an escrow account to set money aside for property taxes, mortgage insurance, and homeowner’s insurance.
Escrow Account: As mentioned above, the escrow account acts as a third-party manager of funds. In this case, part of your mortgage payment is set aside in the account to pay for expenses. The account manager automatically disperses payments as needed.
In the majority of cases, your lender will require you to have an escrow account to cover property taxes, mortgage insurance, and homeowner’s insurance. This account protects the lender (failure to pay property tax could mean a lien on the home). This is convenient for the homeowner, too, since you won’t have to remember to make those payments. The title agent or attorney will set up this account, and you cannot make withdrawals from this fund.
The escrow account is funded either from a portion of the closing costs or you front the cost for your first year of expenses, and then begin making payments to fund the next year’s escrow expenses.
Your escrow payments are reviewed annually and may go up down if property taxes change, the property value adjusts, or you qualify to get rid of your private mortgage insurance.
For a buyer, entering into escrow is a good-faith agreement that you intend to move forward with the purchase. Escrow provides comfort to the seller who can remove their home from the market, confident that they’ve sold their property. Once you own a home, an escrow account is a simple way to make sure all of your taxes and insurance are paid on time. An escrow account protects you and the lender if something unfortunate happens. Escrow is a safety net, and a needed one, as purchasing a home may be one of the biggest expenses of your life.