Escrow accounts are a crucial part of the real estate closing process, but not many people are well-versed in the intricacies of what this means. For as important as escrow is, many homebuyers (and even sellers) may be wondering, “what is escrow?” This legal concept is a crucial protection for both buyers and sellers, though there are some pros and cons to consider. Keep reading to learn exactly what escrow is and why it is used.
Escrow Definition: What Is Escrow?
In its simplest form, escrow serves as an intermediary between two parties trying to facilitate a transaction. More specifically, it’s a safety net extended to both sides of the transaction until the deal is closed and the property or asset officially changes hands. This position allows buyers and sellers to exchange important items, like earnest money and contracts, without fear of malicious intent.
To be clear, escrow isn’t literally a place but rather a third-party — most likely someone from a closing company, an attorney, or a title company agent. When you place essential items in escrow, you give them to a representative who will hold onto them until predetermined criteria are met. This representative will make sure everything proceeds smoothly and ethically, including the transfer of money and documents. That way, you can trust a professional representative with the most important aspects of a real estate transaction instead of a homeowner or buyer you just met.
Types Of Escrow
The escrow process is used with several different investment types to protect buyers and sellers. Here are just a few investment types that commonly facilitate transactions through escrow:
Real Estate: In real estate, escrow allows homebuyers and sellers to safely exchange contracts, earnest money, and more during the closing process. Escrow provides buyers and sellers the option to exit the transaction if certain contingencies are not met during closing. This agreement protects and satisfies both parties until the property is officially sold.
Online Sales: An online escrow process allows investors to buy and sell valuable items, such as jewelry or collectibles, with protections on the sale. Online escrow companies charge service fees to act as intermediaries when these goods are bought and sold. These companies verify the products and funds are received before releasing them to the buyer and seller, respectively.
The Stock Market: Escrow is frequently used to exchange stocks, which can lengthen the overall transaction. This tactic is frequently used when executives or employees are granted shares as part of their compensation, as it forces a waiting period before the stocks can be sold.
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Pros & Cons Of Escrow
Escrow can be a great way to protect high-value investments during a transaction — but there are some pros and cons to consider. Whether you are buying or selling, here are some factors you should be aware of about the escrow process:
Pros Of Escrow
The escrow process is used almost anytime high-value goods are bought and sold, but why is that? Here are some of the biggest pros to consider when using escrow:
Escrow provides buyers and sellers the option to back out of the transaction if the conditions of the contract are not met.
Intermediaries will typically validate the funds, assets, and more before the investment switches hands.
In some cases, escrow allows buyers to submit monthly payments rather than a lump sum.
Cons Of Escrow
Despite its many benefits, the escrow process is not entirely perfect. Here are some of the cons associated with using escrow:
The estimated costs may not always be accurate, this is especially important during real estate transactions where appraisals and tax assessments can change.
Escrow representatives charge a fee for their services, which can be quite high depending on the provider.
As a buyer, escrow can tie up your money until the transaction is complete. Depending on the type of investment this can take some time.
How Does Mortgage Escrow Work?
As I already alluded to, escrow isn’t necessarily a place but rather a position. When you place things in escrow, you hand them over to an intermediary (called an escrow officer). The exact individual representing your impending transaction may be different, as customs vary by state. However, regardless of who represents your escrow, the same rules apply. Everything entrusted to the escrow agent will remain protected and in the third party’s possession until each predetermined condition in the original sales agreement has been met. In other words, money and documents won’t change hands until each side of a transaction has fulfilled their promises.
Picture escrow as a safe, one that each side of a transaction will place their belongings into. Sellers will typically place important documents and contracts in escrow, while buyers typically place earnest money and other checks inside. In other words, this “safe” will hold the things each side wants out of the deal. It is worth noting that no one side controls the safe; that’s the escrow agent’s job, as they are an unbiased third-party (and the best way to ensure things move ahead smoothly). Therefore, the only way to “open the safe” is to complete a list of predetermined criteria that each side puts forth. That way, only once each side is satisfied with the other’s effort will the safe be opened and the contents distributed to their new owner.
To ensure that each side complies, the escrow officer will receive documentation detailing each side’s criteria. And, according to Realtor.com, “every time one of those steps is completed, the buyer or seller signs off with a contingency release form; then the transaction moves on to the next step (and one step closer to closing).”
Example Of Escrow
An example of escrow can help better illustrate how the process works in practice. Let’s say Nick has an offer accepted on a property in San Diego. It’s time to enter escrow, where he is required to put $7,500 forward in earnest money. This money will eventually go towards the purchase of the home, but for now, it is a gesture to show he is serious about buying the property. This earnest money will not be accessible by the seller and instead will sit in the escrow account.
The seller of the home can then finalize repairs on the property, take the home off the market, and get ready to close the deal. In some cases, they can place paperwork and other contracts in escrow. If all goes well during the inspection and appraisal, the sale will move forward, and the escrow process would end at the time of closing. At that point, the money, documents, and property would be exchanged.
Does Escrow Pay Property Taxes?
Escrow does not pay your property taxes for you, at least not in the sense many would hope. Instead, your lender will set up an escrow account for you to contribute to monthly. As a result, you can pay your property taxes from the escrow account. In fact, in addition to setting up the escrow account, most lenders will estimate your annual homeowners insurance premium as well. That way, you’ll know exactly how much you owe in insurance and property taxes every year, and you can proceed to make monthly installments based on the final estimate.
When you pay your mortgage, you can add the additional amount you owe in property taxes and homeowners insurance, and the lender will place it in the escrow account. When enough money has been saved in the account, the money will be taken out and used to pay off the obligations.
It is worth noting, however, that your taxes and insurance premiums will change over time. Do not assume your contributions will remain the same, year in and year out. Be sure to double-check the amount you are paying is correct.
Do Escrow Accounts Earn Interest?
There isn’t a bank out there that is required to pay out interest on escrow accounts. But, of course, that doesn’t mean there aren’t any that do, but instead that none are required by the U.S. Department of Housing and Urban Development (HUD) to do so.
The answer isn’t a simple yes or no; there are far too many exceptions and rules to break down in a simple article such as this. Just know this: You are more likely to earn interest on an escrow account if you live in Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont, and Wisconsin.
What Do I Do While In Escrow?
First and foremost, consult the escrow agent representing the transaction as soon as possible. The only way you can know how to proceed accordingly will be to follow the rules set forth by the officer put in charge of the account. That said, talk straight to the source, as the key to facilitating a smooth transaction is none other than to understand the specific escrow’s instructions. Then, ask specifically what you can do to expedite the process. In my experience, the best thing is to be punctual and prepared. Not only should you have everything you will need, but you should also be able to get it at a moment’s notice.
How To Get Out Of Escrow
The escrow process is typically initiated once an offer on a property has been accepted. In other words, it’s only after a legal contract has been formed between the buyer and seller that the escrow process will get underway. Depending on what is included in the contract, getting out of escrow isn’t always possible. That said, there are ways to remove yourself from the escrow process and terminate the impending sale, but they are not always within your power. Predetermined contingencies may be drafted (per the contract) to terminate the impending sale if specific criteria are not met.
Contingencies are the closest things buyers have to a safety net; they offer a way out of a deal if something is — more or less — out of place. Inspection contingencies, for example, will typically allow buyers to back out of a deal they have already entered into if the inspection comes back with anything unexpected. And contingencies don’t stop there; they can act as a safety net for any number of issues — so long as they were agreed upon at the time of the contract by both the buyer and the seller. There are several ways to get out of escrow, but they depend on the contingencies set forth at the time the contracts were signed.
How To Change Homeowners Insurance With Escrow
As I already alluded to, your lender will typically set up an escrow account in your name. That way, you can put money into the escrow account for your homeowners insurance and property taxes. According to Esurance, “When you make your mortgage payment each month, a certain amount is deposited into your escrow. Your lender then makes payments toward those home-related expenses from your escrow account.”
It is safe to assume a portion of the money you are paying into the escrow account has already been dogeared for a particular insurance company. So if you change your insurance policy while using an escrow account, you must notify the lender controlling the account. They won’t know to allocate the payments elsewhere unless you notify them of the change. There are a few important things to consider. For starters, make sure your new policy is in place before you cancel your old one, and familiarize yourself with any penalties you may incur by switching over.
Escrow accounts are no secret in the investing world. The process is used to buy and sell real estate, stocks, and many other asset types. However, not many people understand the details of these third-party intermediaries. 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.
Have you ever used escrow when buying or selling an asset? Share your experience in the comments below.
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