What Is Escrow And How Does It Work?

What Is Escrow And How Does It Work?

Purchasing a house is a challenging task that most buyers are unprepared for and unfamiliar with. If you have ever bought a house, you must’ve come across terms like escrow mortgage or putting money in escrow. But what does escrow mean?

Escrow is a legal process that plays a crucial role in real estate transactions. In simple terms, it is a process that takes place from the time the seller accepts the offer on the house to the time when the buyer takes possession of the property.

But most home buyers who have made an escrow payment do not grasp what exactly happens. To make things easier, let’s dig deep to find out what an escrow is, what it is used for, and how the escrow process works for the benefit of home sellers and buyers.

Escrow Meaning in Real Estate

An escrow is a legal holding process that stores your assets and funds until certain conditions of the agreement are followed through. In general, a trusted third-party is the escrow and releases the funds only under two conditions:

  • When an appropriate instruction is obtained.
  • When the predetermined obligations in the contract are carried out.

In simple terms, escrow acts as an intermediary between two parties trying to facilitate the property’s closure. This safety net is available for both sides of the transaction until the deal is closed and the asset is officially transferred from one party to another.

As per escrow definition, this position enables both homebuyers and sellers to exchange important documents and assets such as contracts and earnest money deposits without worrying about malicious intentions. This legal process acts as the middle ground until both parties are fully satisfied, and the transactions can proceed.

Escrow Explained in Detail

While signing a real estate purchase agreement, there will be an initial money deposit as part of the process. It involves an upfront amount that is part of the down payment in most cases. This up-front deposit assures the seller that the buyer is committed to purchasing the house.

To protect the interests of both the home buyer and seller, the money deposit is held in an escrow account. An independent third-party is hired to manage this account till the conditions are met to close the deal on the house.

What Is Escrow Account? 

Now that you’re aware of escrow real estate let’s find out what is an escrow account?

An escrow account is a real estate contract or agreement where an independent third-party, otherwise known as the escrow agent or provider, receives and distributes the funds to the transacting parties involved. Usually, the seller’s agent opens an escrow account through a title company or a law firm once the potential buyer and the homeowner agree on the home’s value and sign the real estate purchase agreement.

While purchasing a house in the real estate market, the escrow account is mainly used for the following reasons:

  1. To hold the seller’s funds for homeowners insurance and property tax payments.
  2. To safeguard the potential buyer’s earnest deposit, the funds go to the concerned party as per the conditions in the purchase agreement.

Escrow Vs Escrow Accounts: Is It The Same?

When it comes to mortgages, escrow and escrow accounts are two concepts that are slightly different.

Escrow Escrow Account
Refers to a process. Usually an account.
Third-party intervenes in real estate transactions to hold money and property in escrow till all the conditions are met for closure. Helps in managing the mortgage borrower’s insurance costs and annual taxes.

How Does Escrow Work?

The twofold purpose of real estate escrow is to safeguard the interests of both parties involved throughout the real estate property sale process. Escrow offers a guarantee to the homeowner that the prospective buyer has the necessary funds needed for the purchase and gives the assurance that the money will be handed over once the ownership title is transferred. It also guarantees the buyer that they won’t be scammed by fraudulent homeowners who do not hold any claims to the ownership title.

How Does Escrow Work?

In addition to the earnest money deposits made by the buyer, the escrow account usually holds funds related to the down payment, closing costs, and any other assets or funds that are part of the real estate transaction. Once the home closing is complete, the escrow agent will distribute all the funds mentioned in the mortgage agreement and real estate contract. The escrow payments include the following:

  • Loan origination.
  • Insurance and title fees.
  • Purchase funds from home loans.
  • HOA dues.
  • Real estate agent’s commissions.
  • Any other closure costs are detailed in the final Closing Disclosure.

The escrow provider carefully follows the details mentioned in the real estate purchase contract and the written instructions of the lender so that all the money and assets reach the concerned party without fail.

For high-stakes real estate transactions, getting a home escrow ensures ultimate trust and protection, especially when both parties are unfamiliar with one another and can lose a lot.

Do Both Parties Involved Require Escrow Protection?

Suppose a potential buyer shows interest in the property put up on the market. In that case, the seller tends to accept the offer if the buyer agrees to the conditions stipulated in the purchase agreement. As soon as a seller accepts the home offer, they take the house off the real estate market. If the buyer wishes to back out after accepting the offer, the seller often holds the right to keep the earnest money from the down payment as compensation.

Similarly, suppose the seller makes any defaults in the contract. In that case, the earnest money accepted by the seller must be returned to the buyer, in turn releasing the buyer from the purchase agreement. The two conditions of default by the seller happen when:

  1. They do not satisfy the purchase agreement terms.
  2. They do not deliver the house in the same condition when the real estate contract was created.

When the above-mentioned cases occur, the escrow agent or escrow officer carries out the agreed-upon escrow house terms and conditions set in the contract and provides the funds to the concerned parties.

Who Is An Escrow Provider?

Escrow is mostly used in the real estate market to make monthly payments of the mortgage, especially for expenses such as taxes and insurance, often included in the monthly payment. For real estate transactions, your escrow provider holds all the funds and documents of the property in escrow for both the home buyer and seller. This hired third-party isn’t a place but can be anyone legal, which includes:

  • A title company agent.
  • An attorney from a law firm.
  • Someone from an escrow company.

When you place your assets and funds in escrow, you technically hand them over to a representative who holds them on your behalf until the predetermined conditions are carried out. This legal representative will make sure the proceedings are carried out smoothly and ethically, including the transfer of legal documents and money.

The main aim of the escrow provider is to protect the funds and safeguard the interests of all parties involved. The interests of the buyer and seller get satisfied when all the terms and conditions of the mortgage agreement and purchase contract are met. In this way, you can relax and trust the professional escrow provider with the crucial aspects of the real estate transactions instead of solely relying on the homeowner or potential buyer you recently met.

What Is Escrow Used For?

Escrow plays a crucial role during the initial home purchase and while making the monthly loan payments. In other words, escrow is a legal means of shielding your transaction and making sure that fraudulent practices do not happen. In general, escrow is mainly used for the following purposes:

  • Securing the transactions while purchasing a house –  

The escrow account opening for buying the house is short term. After the seller makes an offer on a real estate property, the homeowner can claim a certain amount as earnest money from the buyer if the offer gets accepted. The buyer then deposits this amount in the escrow account.

Once the real estate purchase deal is finalized and all the necessary mortgage documents and paperwork are signed, the escrow company will release the earnest money deposit. The buyers usually get this amount back, which can be included in the down payment and mortgage closure costs.

  • Paying property taxes and insurance premium amount –

After finalizing the house deal, the escrow lender will open a mortgage escrow account to make the mortgage loan payments. So, What is mortgage account, What is mortgage escrow and what does it do? A mortgage escrow account is opened to make loan payments and lasts throughout the life of your loan term. With the help of a mortgage escrow account, you can make monthly mortgage payments to the lender to pay off the homeowner’s insurance premium and property taxes.

When the insurance payments and property taxes are due, the lender will use this account to pay off the bills on your behalf. This will prevent any late payments from happening. Typically, the mortgage company holds the money in the escrow account.

Opening an escrow account is a must for most lenders, especially when securing funds for more than 80% of your home’s value. This serves as a stress-free option for first-time homebuyers. They can enjoy a smooth budgeting process where the lender automatically pays off the monthly loan payments on behalf of the homeowner without any defaults.

What Is Escrow On A Mortgage Account? Explained

When the homeowner pays the monthly mortgage, part of the payment goes to the mortgage servicer, and the rest of the amount ends up in the escrow account for paying off the following:

  • Property taxes.
  • Insurance premiums like Mortgage insurance.

When the tax and insurance bills are due, the escrow uses the money in the escrow mortgage account to make the necessary payments. If more funds accumulate in the escrow account from the monthly mortgage payments than required to pay off the bills, the mortgage company will send the homeowner a refund check. In some cases, the mortgage company may reduce the amount you need to pay as a monthly loan payment instead of providing a refund.

Meanwhile, if the property tax expenses or the insurance premium goes beyond the specified balance in the escrow account, the mortgage holder will execute any one of the following:

  • Send the homeowner a bill for the difference in amount. Or
  • Increase the monthly mortgage payments.

Escrow Process

The first part of the escrow process involves opening an escrow account to hold deposits of funds, assets, and other payments. During the process, the buyer has to secure finance, get bank approval, complete inspections, conduct walk-throughs, and purchase insurance before going through the home closure.

In general, the escrow amount ranges between 1% – 3% of the total selling price. Once the seller has accepted the home offer, this amount is deposited in the escrow account. The escrow provider holds the funds secure till the sale is finalized, and the ownership title is transferred to the buyer. Depending on the length of the home closing period, the funds remain in the escrow account.

During the escrow process, the funds in the account are not accessible by both the homeowner and the buyer. In case the stipulated conditions of the agreement are not met, or a problem has been noted while inspecting the property, the buyer has the freedom to walk away from the contractual agreement. In such cases, when the deal falls through, the earnest money deposits in the escrow account will be returned to the potential buyer.

Role Of Both Parties In The Escrow Process

As homeowner and potential buyer of the real estate transaction, in addition to depositing funds and assets in the escrow account on time, both parties must also do the following things to ensure a smooth home closure process. This includes:

  1. Carefully go through all the escrow related documents and make sure you understand all the terms and conditions mentioned.
  2. Reading the closing documents thoroughly to avoid any last-minute hassles when finalizing the deal.
  3. Being available at all times to respond to queries or necessary proceedings as the transaction proceeds.
  4. Keeping the escrow-related documents safe for tax and administrative purposes.

Escrow Payment Meaning

Once you have funds in your escrow account, you must be wondering how to use escrow to make monthly loan payments? After purchasing a home from the seller, you will have to pay the property’s state and local property taxes and insurance premiums.

The home insurance premium and property taxes are escrow payments you need to pay to the escrow account. The escrow account makes sure that the buyer has sufficient funds in the account to pay off the taxes and premiums on time without defaults.

The escrow provider does not want the buyer to miss out on tax payments and risk a home foreclosure. They also make sure that the homeowners do not miss out on insurance payments, or the lender will be forced to fork out extra insurance on behalf of the homeowner. The insurance coverage helps protect the house in case of any severe damage or property loss.

What Is Escrow Balance?

If your mortgage is held in an escrow account, then the monthly loan payments are split into different parts, which include:

  1. Principal.
  2. Interest.
  3. Balance.

Initially, most of the monthly mortgage payment goes for paying off the interest, and eventually, it pays off the principal balance. The final part of the payment goes to the escrow balance to pay off the property taxes and insurance premium incurred. Periodically, the escrow company conducts an escrow account analysis, after which the monthly payment amount may vary.

What Does It Mean To Be In Escrow?

The term ‘in escrow’, refers to all the funds and assets placed in the escrow account, which includes:

  • Property deed.
  • Loan funds.
  • Earnest money deposit

All these items are held by an independent escrow provider and cannot be released till all the stipulated conditions of the escrow agreement are satisfied by both parties involved. In general, the conditions in the escrow arrangement include title search, approved financing, and receiving an appraisal.

As long as the earnest money deposit is in the escrow account, neither the homeowner nor the buyer can release any amount from the account. Once the conditions are satisfied, the earnest money will be included as part of the home’s down payment or purchase price.

Final Thoughts

Escrow plays a crucial role while buying a house and protects the interests of both homeowners and buyers while closing the deal. As buying a house is one of the biggest investments you will have to make, having an escrow account is a huge relief for homeowners to make critical payments on time without delay.

However, it’s not always necessary to have an escrow account, as it depends on your financial profile and the type of loan you procure. Though it can be tempting to avoid opting for an escrow account, having one will lower your monthly mortgage payments and give you peace of mind, as your lender takes responsibility for paying bills on your behalf.

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