An escrow is a legal agreement in which a third party (aka, the escrow provider) holds and oversees funds, paperwork, or other assets on behalf of two other parties during a property transaction. The funds are kept in a secure escrow account until the terms of the legal agreement have been met.
What is an escrow?
An escrow is a type of financial agreement, most commonly used during the purchase of a home or other property. The escrow account holds the funds until the first two parties consent to the terms of the agreement. Basically, an escrow makes a contract more secure by protecting the assets laid out in the agreement.
Escrow accounts also help keep your payments in order, after you’ve purchased a property. When your homeowners insurance and property tax is due, your lender can use your escrow account to pay.
Is there more than one type of escrow?
There are two types of escrow accounts: One is used during the home buying process, and the other comes into play during the lifetime of the loan.
1) During the home buying process
When buying a home, your agreement with the seller will have a good faith agreement. This is a small deposit (typically 1-3% of the sale price) that shows the seller you’re serious about buying the property. That deposit is called ‘earnest money.’ If the sale goes through, the money goes towards your down payment; but if it falls through, the seller gets to keep the money. In the meantime, that earnest money sits in an escrow account until the property agreement has been finalized.
2) Lifetime of the loan
Once you’ve purchased your home, your lender might open an escrow account to pay for your taxes and insurance. They’ll take a portion of your monthly mortgage payment and set it aside to cover property tax and homeowners insurance. Because your taxes and insurance premium can change from year to year, your lender will ask for approximately 2 months of extra payments to ensure there’s always enough cash in escrow. If you’ve deposited too much money in your escrow, your lender will return the difference to you; if you’ve deposited too little, you’ll need to cover the difference.
BTW, if you refinance a mortgage, a brand new escrow account will be opened. Escrow funds can’t be transferred to your new loans, even if you’re using the same lender. But all the property tax and homeowners insurance payments you made to that account, since the last payment was made, will be refunded to you.
What escrow accounts don’t cover
The funds in your escrow account won’t be used to cover expenses related to homeownership. For instance, your utility bills, or HOA fees.
Do I have an escrow account?
Not sure if you have an escrow account or not? If you want to be sure, look at the bottom of your mortgage statement, where any escrow balance would be displayed.
How an escrow works (for real)
Doug and Bill are on the market for a home. After being pre-approved for a loan they find the perfect condo for $650K in an ideal part of the city. After deciding to go for it, they enter into a good faith agreement, putting down ‘earnest money’ as a deposit: $16,250, or 2.5% of the total property price.
That money goes straight into an escrow account set up by the title company or real estate broker. Once their offer is accepted, Doug and Bill go ahead and get a home inspection, and later sign the contract. Next step is to finalize their mortgage, and now the lenders send a home appraiser to the property.
Doug and Bill now need to purchase some homeowners insurance, a required part of their mortgage agreement.
A new escrow account is opened to manage their property tax and homeowners insurance payments. Their friends are happy for them and keep asking when the closing date is. ‘The house is still in escrow,’ they say, ‘but we have our fingers crossed!’
All that’s left is to celebrate and finally move in (the funds in that escrow account, though, can’t be used to buy the cake and champagne).