“Escrow” is a term that comes up frequently in real estate transactions, but oftentimes, neither buyer nor seller fully understands how it works. Escrow is mandatory in most 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 homebuying process. Learn more about what escrow is, how it works and the different types of escrow accounts:
— What is escrow?
— How does escrow work?
— Different types of escrow accounts.
— The benefits of having an escrow account.
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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,” explains Eddie Martini, strategic real estate investment advisor at Real Estate Bees in the greater Sacramento, California, area.
Essentially, it allows both parties in the 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, Martini says.
How Does Escrow Work?
Greg Forest, senior global real estate advisor for Sotheby’s International Realty in Palm Beach, Florida, says that 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,” Forest says. “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, Martini explains. “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 a new escrow opened with the company of their choice. This is state by state and in some cases, county by county,” Martini says. “Some states and counties allow for title and escrow to be one company, while others require them to be separate companies.”
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Different Types of Escrow Accounts
In real estate, there are two different types of escrow accounts — one during the buying process and another used after purchasing a home, explains Forest.
Escrow Account for Buying a Home
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. 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 Account for Paying Taxes and Insurance
While escrow is used during the home buying process to protect all parties in the transaction, Forest says an escrow account is also used to hold the homeowner’s funds for property taxes and homeowners insurance.
To minimize the risk of defaulting on the loan or incurring liens on the property, lenders want to make sure you pay 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 keep these funds to pay bills 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.
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The 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 is the biggest benefit,” Martini says. “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, the end will result in what you had planned for.
“Without having an escrow account and a neutral third party, you are relying upon the other person to be true to their promises and that is a dangerous assumption to have when it comes to business.”
For homeowners using an escrow account, it can alleviate the stress of coming up with a large payment to cover taxes and insurance. “It also simplifies budgeting for homeowners, spreading out large annual expenses into smaller monthly payments,” Forest says.
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What Is Escrow? originally appeared on usnews.com
