If you're in the market for a new home, you've probably heard people mention "escrow." If your response is "how does escrow work," you're not alone.
Here is everything you need to know about escrow and how homebuyers and sellers can use it to their advantage.
What Is Escrow?
Escrow is a financial agreement where a third party temporarily holds money. The third-party releases the funds once the parties meet the conditions of their contract.
There are many different ways to use escrow, though most people use it to manage homeowners insurance premiums or property taxes.
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How Does Escrow Work?
Two of the most common questions we get are, "How does escrow work when selling a house?" and "How does escrow work when buying a house?" The answers are markedly similar. Here is a step-by-step guide.
The first step is for the buyer and seller to agree on terms and conditions. The buyer then gives an agreed-upon amount of money to a third party.
The third-party verifies the payment and notifies the seller when they secure the escrow.
The seller transfers ownership of the item to the buyer, in this case, the home. The third-party waits for the buyer to accept the house within a set number of days.
Once the buyer approves the transaction, the third party sends the seller the funds.
Escrow is a secure transaction for all parties involved. It lets the buyer confirm the quality of their purchase, and the seller doesn't have to worry about extending their property without compensation.
Buyers and sellers typically use a bank or lawyers to establish escrow account rules and hold the money, though there is an increasing number of online escrow options.
Advantages of Using an Escrow Account
Escrow provides certainty for sizeable transactions. It protects buyers and sellers equally and creates a platform to resolve disputes.
For Example:
Let's say a homebuyer discovers faults with the house during an inspection.
They can address those concerns without making a significant financial mistake.
Escrow demonstrates good faith between parties. The buyer makes an initial deposit, known as earnest money, to show they're serious about buying.
If the home buying process is successful, lenders apply this deposit toward the down payment. If the sale falls through, the seller often keeps it.
The process simplifies homeownership, too, eliminating the need to manage various financial due dates.
When insurance premiums or property taxes arrive, the bill is paid on time, every time.
Lenders benefit from escrow arrangements because they guarantee that borrowers make their tax and insurance payments.
Lenders closely monitor escrow, because if they don’t have adequate funds, the local tax authority can place a lien on the property. Liens cost lenders money if there is foreclosure.
The same logic applies to insurance coverage. Lenders want on-time payments to maintain proper insurance in case of property damage.
Lapses in coverage leave lenders open to the risk of paying money out-of-pocket to repair damages.
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Disadvantages of Using an Escrow Account
While millions of people use escrow to secure the purchase and sale of a home, it has potential shortcomings, primarily for the homeowner.
For example, escrow requires making higher monthly mortgage payments, even if they are applied towards necessary costs (homeowners insurance and property taxes).
Taxes and insurance premiums can change each year, especially when you move or have a property value reassessment.
If you’ve owned a property for a while, the odds are your property taxes will jump substantially.
Your escrow servicer may not consider these jumps when managing your account. If that happens, you're more likely to end up short on payments, and you'll have to pay the difference out-of-pocket.
If you have excess funds in your account, your servicer will send you a check for the remainder.
Are Escrow Accounts Exclusive to Mortgages?
Most people use escrow for mortgages, but they are hardly exclusive. Anytime there is a financial transaction, escrow is an option to facilitate the arrangement.
One example is escrow.com, which handles transactions for more than a million customers globally.
People use escrow for electronics, art, jewelry, general merchandise, cars, domain names, rental deposits, and even cryptocurrency.
Regardless of what you are buying or selling, make sure the third party has the appropriate credentials.
Qualified escrow parties should have a license, bonding, and regular audits to ensure sound business operations.
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Agents not required.
Get quotes and sign up online without talking to an agent. But, we are here if you need us.
Unbiased, expert advice.
Get unbiased insurance education from licensed experts and also avoid dodgy sales calls.
Coverage in minutes.
You can get home insurance coverage within minutes of getting your quotes and applying.
It is possible to get an escrow refund. Refunds typically happen after you pay property taxes or insurance, and there is money left in your account.
Servicers call this a surplus or escrow overage.
There are federal regulations that oversee how much money you can have in escrow.
It should be no more than the annual cost of insurance and property tax, plus a small cushion in case of property reassessment.
If you owe $3,600 in insurance and property tax per year, your escrow account can’t exceed $4,225.
Any overage means money back in your pocket. Your servicer will calculate the difference and send you a check in the mail.
Generally, your monthly escrow payment is adjusted when you are sent any excess or billed for shortages.
You may also be eligible for an earnest money escrow refund when buying a home if there are unmet contingencies.
For instance, many real estate deals are contingent on the results of a home inspection.
If undisclosed issues are found during the inspection, and you can’t come to a new agreement with the seller, your escrow is refunded.
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Escrow is a financial arrangement that ensures secure transactions between buyers and sellers. A third party oversees the deal for a smooth transition from start to finish.
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