You have probably heard the term “escrow” mentioned before, most likely by someone buying or selling a house. But if you’ve never gone through the homebuying process yourself, you might not have a clue as to what this term really means.
What is Escrow?
Put simply, escrow is a third-party financial arrangement intended to protect both sides of a large sale. It is most often used in real estate transactions, though you will likely come across the use of throughout the course of your mortgage loan repayment.
How Escrow Works
Escrow offers the seller and the buyer a way to securely transfer funds, while ensuring that neither party is able to undercut the other. The accounts are managed by an unbiased and impartial service, who will accept and hold the money involved in the sale until all terms are met. Then, and only then, will funds be released.
Escrow begins when two parties agree to proceed with a transaction. When buying a home, that would be when a seller accepts your purchase offer.
As a buyer, you’ll be asked to put up earnest money when proceeding with an accepted offer on a home. These funds -- ranging from a few hundred dollars to 2-3% of the home’s value, depending on the market at the time -- are your way of committing to the purchase.
The earnest money you put up goes into an escrow account, rather than being given directly to the seller. It will be held there until closing, when all parties have satisfied their end of the purchase agreement.
If the seller backs out or cannot complete the sale, these funds are returned to you. If you back out, the seller often keeps this money in exchange for the time they lost while their home was off the market. However, if the sale goes through as planned, this money is typically applied to your closing costs and/or purchase price.
Mortgage Escrow
You could also encounter escrow again, long after the purchase of your home, in the form of mortgage escrow.
Your lender may choose to use an escrow account for things like property taxes, homeowners insurance, etc. These funds will be taken out monthly along with your principal mortgage payment, and held in an account by the lender. When property taxes or insurance premiums are due, they will be paid out from this balance.
Things to Remember
There are a few things to keep in mind regarding escrow accounts when buying a home.
First, real estate escrow services aren’t free. There will be an added cost at closing for this third-party service, which is often split between the buyer and seller. Escrow fees don’t typically cost more than a few hundred dollars, but it is still something to note.
Second, the funds held in escrow won’t typically earn interest for the customer, even if they’re being held at a banking institution.
So, the next time you hear about someone being “in escrow” -- or start the process of buying your own home -- you’ll know exactly what it means. Escrow is a necessary process for any home purchase, protecting funds for all parties involved.