When you take out a new mortgage, your lender will most likely require you to pay into an escrow account. This is a routine part of the normal closing process, and it’s nothing to be concerned about. But if it’s your first time buying a home, this can be confusing. Unless you’ve been through the process a couple of times, you’re probably wondering what “escrow” even means.
Escrow is an important legal term to understand if you’re involved in the homebuying process. So what is escrow? Here’s everything you need to know, from the basic definition to why escrow accounts are so important. Let’s get started!
What Is Escrow?
Escrow is a process where a third party holds money on behalf of two other parties that are engaging in a financial transaction. Typically, this means that the third party is holding money, but that doesn’t have to be the case. They can also hold stocks, real estate, securities, and various other assets. The bottom line is that the third party has no legal ownership of the escrow account but is simply acting as a custodian.
How Does Escrow Work?
The third-party who acts as custodian of the escrow account is known as the “escrow agent.” Depending on the state, different people may act as an escrow agent during the mortgaging process. This person may be an agent of the title search company, someone from the real estate agency, or an independent attorney. Their job is to ensure that money and documents are transferred from one party to another, and that the escrow funds are held until the appropriate time.
Escrow accounts are designed to protect all parties to a real estate purchase. These include the buyer, the seller, and the lender. Since funds are held in escrow, the lender knows that you actually have the money for the down payment and other expenses. Meanwhile, the buyer knows that the money will not be disbursed until inspections and other necessary processes are complete. The seller knows that they’re not wasting their time, and that the process is being handled in an aboveboard fashion.
Money will be held in escrow until several steps have been completed. There will need to be a home inspection, and you’ll need to get final approval for your mortgage. Depending on the results of the inspection, some repairs may be necessary. Each time one of these things is done, the buyer or the seller will sign a contingency release form, which is delivered to the escrow agent.
When all the necessary steps are completed, you’ll be ready to close. At that point, the escrow agent will verify that all the contingency release forms were signed, and disburse the funds. At the same time, the lender will release their own funding to the seller, and an escrow officer will record the new title.
[ Rental property investor, rehabber or wholesaler? Get to know which investing strategy is the best fit for YOU by attending our FREE online real estate class. ]
What Is an Escrow Account?
Escrow accounts can be used in many contexts. In real estate, it’s used for two main reasons:
To secure the buyer’s good faith deposit and ensure that the money is delivered to the seller or the lender as stipulated by the terms of sale.
To hold payments for homeowners insurance and property tax.
Strategize the strengths and weaknesses of the company.
The good faith deposit is a one-time event, while insurance and property taxes will continue to be required for the life of the loan. For this reason, there are two main types of real estate escrow accounts.
Home Buying Escrow Accounts
In most cases, a home purchase agreement requires you to put down a good faith deposit. If you back out of the purchase later on, the seller will typically be allowed to keep the deposit. If the seller cancels the sale, the deposit reverts to you. In most cases, when the purchase is complete, the deposit is applied towards the down payment at closing.
So, a deposit is being put down. But depending on how the sales process goes – or doesn’t go – the deposit might go to the seller or the lender, or be returned to the buyer. In order to ensure that the money is handled properly, the buyer deposits it into an escrow account that’s set up by both parties.
Normally, a home buying escrow account is closed out at the same time as the real estate closing. But in some cases, some or all of the money is retained in what’s called an “escrow holdback.”
An escrow holdback is performed when there are still further conditions to the sale. For example, the buyer may have found a serious issue during the final walkthrough. In that case, the release of the funds might be contingent on the seller completing those final repairs. In other cases, the seller may be remaining on the property for a period of time. In that scenario, the money would be disbursed when the seller actually vacates the property.
Tax & Insurance Escrow Accounts
After closing, the buyer still isn’t done with escrow accounts. At that time, your lender will open an account that will be used to pay for taxes and insurance. From then on, a piece of each mortgage payment is put aside into the escrow account. When your tax and insurance bills come due, they’ll be paid out of that account.
Because taxes and insurance rates can change, your monthly escrow payments may change throughout the term of your mortgage. This means that your overall mortgage payment can go up or down by a little bit. Generally, this happens at the end of the year, when your lender recalculates things based on the previous year’s costs.
For this reason, lenders like to have some assurance that there’s going to be enough money to cover unexpected costs. In most cases, you’ll need to have a minimum balance of two months’ worth of estimated costs. This means you’ll be charged for the first two months at closing time.
In rare cases, your costs may rise so much during the same year that your escrow account couldn’t cover them. If that happens, you’ll be charged for the difference, although your lender will allow you to make payments in installments. On the plus side, your costs may actually go down, and your lender will send you a refund at the end of the year.
What Escrow Accounts Do Not Cover
Tax and insurance escrow accounts only cover costs that are handled by your lender. It doesn’t cover any costs that you handle for yourself. You’ll still be responsible for HOA assessments, utilities, trash collection, and other ordinary expenses.
They also don’t cover supplemental tax bills, which are one-time fees charged following new construction or a change in ownership. These may or may not be issued, and are impossible to predict far in advance, so your lender has no way to account for them.
Do You Need an Escrow Account?
You don’t always have to use an escrow account to pay your taxes and insurance. Lenders typically require you to maintain one until you have a minimum amount of equity in the house – normally 20% or more. Certain lenders have lower requirements, though. For example, VA loans only require you to have 10% equity to get rid of your escrow account.
Doing this will lower your monthly mortgage payment, but it won’t necessarily save you any money. You’ll still be responsible for taxes and insurance; you’ll just be paying for them out of pocket instead. This is certainly not as convenient as having things handled by your lender.
Who Manages an Escrow Account?
Different parties will manage your escrow account, depending on where you are in the process. Here’s a quick snapshot:
Escrow companies and escrow agents – During the buying process, escrow can be managed by an escrow agent. Most often, this agent is employed by the title company. This makes it easy for them to perform related functions, such as maintaining custody of the deed and other documents. That said, there are also third-party escrow companies which can perform the same function. In either case, the escrow agent is being employed jointly by the buyer and the seller, so billing is normally split 50-50.
Mortgage providers – Once you’ve closed on the house, your mortgage provider will manage your tax and insurance escrow account. In most cases, this will be your original lender, but that’s not always true. Your original lender may have sold your mortgage to a third party. And if you refinance with a different lender, they’ll be taking over responsibility for your escrow account. In that case, you’ll have to provide your tax and insurance information to your new provider. Either way, there are no extra charges for this service; it’s built into the cost of your mortgage.
Pros of an Escrow Account
Escrow accounts are designed to protect the interests of all parties to a real estate transaction: the buyer, the seller, and the lender. It also benefits homeowners after the transaction. Let’s talk about the benefits for each party.
For buyers – Sometimes, a real estate transaction falls through due to circumstances outside your control. For example, suppose you really intend to buy a home, but the inspection turns up black mold in the crawl space. The seller doesn’t want to pay for mitigation, so there’s no sale. But they refuse to return your deposit, claiming that you backed out of the deal. Without an escrow account, you’d spend months in court trying to get your money. With one, you have the assurance that your deposit will be returned.
For sellers – Without escrow accounts, people would be hesitant to make a good faith deposit to begin with. These kinds of accounts give everyone confidence that the transaction will be handled honestly and fairly.
For lenders – Lenders need to be sure that your taxes and insurance are paid. If you don’t pay your taxes, your local tax authority could put a lien on your home, and even seize it outright, which would be a major loss for the lender. If you don’t have insurance and there’s major damage to the property, you might not be able to stay in the home. At that point, the bank will foreclose, but they’ll be footing the bill for major repairs.
For homeowners after the transaction – Homeowners get the benefit of easy budgeting. With an escrow account, you don’t have to set aside money on your own to pay for taxes and insurance. You also don’t have to keep track of any of the billing cycles. Your lender handles everything for you, and it comes out of your monthly bill.
Cons of an Escrow Account
While escrow accounts’ benefits are undeniable, there are also some drawbacks. As it happens, most of these apply to the homeowner:
Higher monthly bills – Because your tax and insurance payments are paid out of your mortgage, your monthly mortgage payment will be higher than it otherwise would be. For some homes, these costs can be significant.
Inconsistent fees – Because escrow fees are recalculated every year, your mortgage payments can go up and down. Obviously, having them go down is a good thing. But if your monthly bill suddenly jumps by 5 or 10 percent, that’s no laughing matter. Then again, even without an escrow account, you’d still have to pay your taxes and insurance somehow.
Bad estimates – When you first move into your house, your property’s value is normally reassessed. If its value has gone up substantially, this will translate directly into higher property tax bills. These bills can continue to go up for the first few years you live in your house. Because your escrow payments are based on an estimate, they might not be enough to cover the balance. Then, at the end of the year, you get a bill from your bank for hundreds or thousands of dollars. This is unpleasant news under any circumstances, particularly when it’s unexpected.
[ Want to create a roadmap to a financially secure retirement? Register for our FREE online real estate class to learn the powerful wealth building strategies real estate investing has to offer. ]
Frequently Asked Questions on Escrow
Before we wrap up, let’s talk about some of the most common questions people have about escrow accounts.
What Is an Escrow Balance?
An escrow balance is the portion of your monthly mortgage payment that goes into your tax and insurance escrow account. Other mortgage charges include the principal (the main loan payment), and the interest.
What Is an Escrow Agreement?
An escrow agreement is a contract between the parties involved in the escrow process. This can be between the buyer, the seller, and the escrow agent, or between the homeowner, the lender, and the escrow agent. Regardless, it spells out exactly how the funds are to be handled.
What Does it Mean to Be in Escrow?
To be in escrow means that the money – or other property – is legally locked up. It cannot be released until the various parties meet the conditions outlined in the escrow agreement.
How Long Do You Pay Escrow?
It depends on the mortgage agreement. Most lenders require you to maintain an escrow account until you’ve paid off a minimum amount of the mortgage balance. Normally, this is 20% of the home’s value, but different mortgages will have different requirements. In most cases, you’ll also need to have made at least 12 on-time payments. On the other hand, you may choose to keep paying escrow for the life of the loan, as a simple way to handle tax and insurance.
What Is an Escrow Disbursement?
An escrow disbursement is a payment that’s made out of an escrow account. For a tax and insurance account, these payments are made to the relevant tax authority and insurance company.
As you can see, escrow is an essential part of the homebuying process. Without it, fewer people would qualify for loans, and there would be no viable way to accept a good faith deposit. As it stands, escrow accounts grease the wheels of the real estate world, and democratize the market for more people. It is not uncommon for first-time homebuyers to wonder, “what is escrow?” even after placing an offer on a property. Use the information above to help fill in the blanks and answer any questions you have about the escrow process. It can be a great way to protect yourself during high-value transactions.
Ready to start taking advantage of the current opportunities in the real estate market?
Whether you’re brand new to investing or have closed a few deals, our new online real estate class will cover everything you need to know to help you get started with real estate investing. Expert investor Than Merrill explains the best real estate strategies to help get you on the path towards a better financial future.
Register for our FREE 1-Day Real Estate Webinar and get started learning how to invest in today’s real estate market!