Escrow in Real Estate Explained

What Does Escrow Mean in Real Estate?

Escrow is a legal arrangement where a third party temporarily holds money, property, or other assets until specific conditions are met. It's a financial agreement between two parties facilitated by an escrow agent. The agent manages the escrow account and ensures that assets are released only when predetermined contractual obligations have been fulfilled. Various types of assets can hold in escrow.

How Does Escrow In Real Estate Work?

Escrow is a financial process utilized in transactions where uncertainties exist regarding fulfilling obligations between two parties. It finds application in various scenarios, including Internet transactions, banking, intellectual property, real estate, mergers and acquisitions, law, and more.

For instance, consider a company involved in international sales. They require reassurance to ensure that the company receives payment upon the goods' arrival at their destination. On the other hand, the buyer is willing to make payment only if the goods are received in satisfactory condition.

To address this, the buyer can place the funds in escrow with an agent and instructions to release the funds to the seller. This arrangement protects both parties and facilitates the transaction. In real estate, escrow is commonly employed to safeguard the interests of both the buyer and seller throughout the home buying process. An escrow account holds funds for taxes and homeowner's insurance throughout the mortgage term.

What’s Escrow Used For?

Escrow is commonly utilized in real estate for two primary purposes:

1.Protecting the buyer's good faith deposit: Escrow ensures that the buyer's earnest money deposit is securely held until the conditions of the sale are met. This safeguards the funds and ensures they are rightfully allocated to the appropriate party.

2.Holding funds for property taxes and homeowners insurance: Another use of escrow in real estate is to hold the homeowner's funds designated for property taxes and homeowners insurance. The escrow account sets aside and manages these funds to ensure timely payment of these expenses.

Due to the distinct functions they serve, there are two types of escrow accounts. One is utilized during the home buying process to protect the buyer's deposit. At the same time, the other is maintained throughout the loan's duration, specifically for managing funds related to property taxes and homeowners insurance.

The Different Types Of Escrow

Escrow And Real Estate

Escrow accounts play a significant role in real estate transactions, benefiting buyers and sellers. By placing funds in escrow with a trusted third party, buyers can demonstrate their commitment to the purchase and carry out necessary due diligence when considering a property acquisition. Simultaneously, escrow assures sellers that the buyer is genuinely interested in the transaction. For instance, both parties may opt to utilize an escrow account when selling a house with specific conditions, such as passing an inspection.

In this scenario, the buyer deposits the payment for the house into an escrow account held by a third party. This enables the seller to proceed with activities like house inspections, knowing that the funds are securely held, and the buyer is financially capable. Once all conditions for the sale are met, the funds held in escrow are transferred to the seller.

Escrow can also refer to the establishment of an escrow account during mortgage closing. Such an account is designed to accommodate future payments for homeowners insurance and property taxes. A portion of the monthly mortgage payment is allocated to the escrow account to cover these expenses. While borrowers with an escrow account may have slightly higher monthly payments, they’re relieved of the burden of paying annual insurance premiums and property tax bills separately. Instead, they make monthly contributions into their escrow account, ensuring these obligations are fulfilled.

Escrow Accounts For Taxes And Insurance

Once you’ve purchased a home, your lender will set up an escrow account to handle your tax and insurance payments. Following the closing, your mortgage servicer allocates a portion of your monthly mortgage payment to this escrow account. These funds are held until your tax and insurance payments come due.

The amount required for escrow can vary as your tax bill and insurance premiums may change annually. To ensure sufficient funds in the escrow account, most lenders mandate a minimum of two months' worth of additional payments to be set aside.

On an annual basis, your lender or servicer will review your escrow account to ensure proper balance. If they determine that an excess amount has been collected for taxes and insurance, they will provide you with an escrow refund.

Conversely, if their analysis reveals a shortfall, you’ll be responsible for covering the difference. You can make a one-time payment or increase your monthly mortgage payment to address the shortage in your escrow account.

Escrow And The Stock Market

Escrow is also frequently utilized in issuing stocks, wherein shareholders are considered the actual owners of the stocks but have restricted rights regarding their disposal.

This is observed when executives receive stocks as part of their compensation package. Typically, they must wait for a specified escrow period before selling the stocks. Stock bonuses serve as an incentive to attract and retain top-level executives within a company.

Escrow And Online Sales

Like escrow services in real estate and the stock market, online escrow safeguards against fraud and nonpayment for buyers and sellers in online transactions. Acting as a trusted intermediary, an online escrow service facilitates product sales by holding the buyer's payment until the product is successfully received.

After the delivery is made and verified, the online escrow service releases the funds to the seller, ensuring a fair and secure transaction. This escrow service is particularly beneficial for high-value items like jewelry or art. However, it's important to note that the online escrow company charges a fee for this valuable service.

Who’s Involved In Managing The Escrow Account?

Depending on the stage of the process you're in, various entities can handle escrow accounts. These may include an escrow company, escrow agent, or mortgage servicer, each fulfilling the role of managing the account based on your situation.

Escrow Companies And Escrow Agents

During the home buying process, escrow management is typically entrusted to a mortgage servicing company or an escrow agent, who may also coincide with the title company.

The responsibilities of the escrow company extend beyond overseeing the buyer's deposit. They’re often entrusted with safeguarding the deed and other pertinent documents associated with the home sale.

As the escrow company acts on behalf of both the buyer and the seller in the real estate transaction, the fee for their services is commonly divided equally between the parties.

Escrow Mortgage Servicers

From closing until your loan is fully repaid, your mortgage servicer assumes responsibility for managing your mortgage. Their duties encompass collecting your mortgage payments, maintaining accurate payment records, and overseeing your escrow account.

While your originating lender may serve as your mortgage servicer, it's important to note that the servicing rights of your loan can be sold to other entities. It's advisable to be aware in advance whether your lender typically services their loans, as not all mortgage servicers offer the same level of service, and some may impose additional fees.

With the presence of your mortgage servicer handling your escrow account, you have minimal tasks to perform. You don’t need to submit your tax or insurance bills; your servicer will ensure they know the payees and payment schedules.

The only exception arises when you switch insurance providers or policies. You may need to provide your servicer with updated policy information in such cases.

Pros Of An Escrow Account

An escrow account offers significant advantages, providing protection and peace of mind during real estate transactions for both buyers and sellers. Additionally, it serves as a safeguard for homeowners, ensuring they have the necessary funds to cover property taxes and homeowners insurance when the bills are due. Beyond these benefits, there are several other advantages for home buyers, owners, and lenders.

For Home Buyers:
One of the key benefits of an escrow account is the protection it offers for your deposit during a home sale if unforeseen issues arise, such as problems discovered during a home inspection leading to the cancellation of the sale, having your deposit held by a neutral third party guarantees its return following the agreement.

For Homeowners:
Having an escrow account relieves the burden of coming up with a lump sum payment to cover taxes and insurance. By spreading out the payments throughout the year, it becomes more manageable and easier to budget. You no longer have to keep track of multiple due dates as your mortgage servicer ensures timely payment of tax bills and insurance premiums. Even if your escrow account is short on funds, your servicer will cover the bills on your behalf, preventing late payments.

For Lenders:
Lenders have a vested interest in ensuring the payment of property taxes and insurance for several reasons. Failure to pay taxes could result in a tax authority placing a lien on the home, which would be costly for the lender if foreclosure is pursued. Similarly, if homeowners insurance coverage lapses, it could lead to significant financial loss if the property suffers severe damage or loss in value. Lenders can guarantee that these bills are paid on time by establishing an escrow account, reducing potential risks.

In summary, an escrow account offers protection during transactions, especially in real estate deals involving substantial sums of money. It enables monthly payments towards insurance and taxes, eliminating the need for a large lump sum payment. Ultimately, it benefits buyers and sellers, mainly when significant financial obligations are involved.

Cons Of An Escrow Account

While an escrow account provides several benefits, there are also a few disadvantages, primarily impacting the homeowner. Here are some examples to consider:

Higher monthly mortgage payments: Since an escrow account is funded through your monthly mortgage payment, it can result in a higher monthly bill compared to not having an escrow account.

Incorrect estimates: The amount required for your escrow is based on property taxes and homeowners insurance costs, which can fluctuate annually. Your servicer determines the amount based on the previous year's bills. However, when you move into a new home, your property may undergo reassessment, leading to a significant increase in property taxes if the home value has risen. This increase in property taxes may occur repeatedly during the initial years of homeownership before stabilizing. Servicers may not account for such substantial tax increases when estimating the escrow, potentially resulting in a shortfall. You'll have to cover the difference out of pocket in such cases. Conversely, if there is any surplus in your escrow after paying taxes and insurance for the year, your servicer will refund the excess funds.

Changes to your monthly payment: Escrow is reassessed annually based on shortages or excess funds. If you have a shortage, your mortgage payment will increase to prevent another shortfall. Your monthly payment may decrease or remain unchanged if there is an excess.

Potential incorrect tax estimates: Estimating tax amounts due can be challenging, and there is a possibility of inaccuracies in the tax assessment, which may result in unexpected tax payment discrepancies.

Online escrow service fees: If you opt for an online escrow service, it's worth noting that the fees charged by these services might be higher compared to other platforms like PayPal.

It's essential to carefully consider these disadvantages alongside the benefits to decide whether an escrow account is suitable for your specific circumstances.

What Will Escrow Accounts Cover Or Not Cover?

While escrow accounts provide convenience for managing certain expenses, it's important to note that they don't cover all homeownership costs. Here are a couple of examples:

Utility bills and HOA fees: Escrow accounts established by your lender or servicer typically focus on property taxes and homeowners insurance. They don’t collect funds to pay utility bills or HOA fees. It's your responsibility to handle these expenses separately.

Supplemental tax bills: Escrow accounts aren’t designed to account for supplemental tax bills. These bills are issued as one-time payments due to factors like a change in ownership or new construction. Since the timing and amount of supplemental tax bills can't be predicted, your lender or servicer won't include them in your escrow calculations.

It's crucial to know that you'll need to manage these additional expenses outside your escrow account to ensure all financial obligations related to homeownership are appropriately addressed.

Should I Get An Escrow Account?

There is an option to pay for property taxes and insurance directly instead of utilizing an escrow account, which can result in a lower monthly mortgage payment. However, it entails the responsibility of saving for these payments independently.

It's important to note that only some can opt out of an escrow account on their loan. Particular loans have mandatory escrow requirements. For instance, VA loans allow opting out with a down payment of 10% or more and a strong credit profile, while conventional loans typically require a down payment of 20% or higher. On the other hand, FHA loans mandate all borrowers to have an escrow account.

Furthermore, it's possible to selectively use an escrow account for specific expenses while excluding others. Sometimes, lenders may only require escrow for property taxes and not homeowners insurance. This allows borrowers to have some flexibility in managing their escrow arrangements.

Escrow In Real Estate - The Bottom Line

Escrow serves a variety of transactions, such as real estate, stock issuances, and online sales. In these cases, the buyer's funds are securely held in an escrow account until the transaction is finalized, or the buyer can confirm the product's condition upon receipt.

Once the buyer approves, the funds are released from the escrow account to the seller. The escrow company responsible for managing the account typically charges a fee for their trusted third-party service. Escrow plays a vital role in home purchases, protecting buyers and sellers and providing a convenient method for managing tax and insurance payments.

Whether or not an escrow account is required depends on the loan type and your financial profile. While forgoing an escrow account may lead to lower monthly mortgage payments, it's essential to consider the peace of mind that escrow provides by relieving you of the responsibility to ensure timely payment of these crucial bills.