What is Escrow?

For home buyers, the word “escrow” pops up plenty. But what does it actually mean? How does it work? Why is it so important in the buying process, as well as when the buyer actually owns the home? Read on to learn more about this real estate term and how it impacts all parties in a real estate transaction.

What Does Escrow Mean?

Escrow is a legal term encompassing the agreement where a third party temporarily holds onto funding, property, or other assets until specific conditions are met ahead of the closing of a home purchase. It’s important for escrow to be held by an impartial third party while the other two parties — the buyer and seller — so the best interest of both are protected.

In addition to escrow accounts for the purchase of a home, there are also escrow accounts for property taxes and homeowner’s insurance. Once a buyer purchases a home, the mortgage lender of their choosing will open an escrow account, which is used to pay for property taxes and homeowner’s insurance. The mortgage lender will take a percentage of the monthly mortgage payment and hold it in this escrow account until these payments for tax and insurance are due.

How Does Escrow Work for Home Buyers and Sellers?

In order for a home buyer to show they’re serious about purchasing the home, they will oftentimes offer earnest money, which is an initial deposit of funds separate from the down payment. This is a type of bid for the buyer to demonstrate to the seller they have ample funding they’re ready to use towards purchasing the home. Once the seller accepts a buyer’s offer on the home, both parties sign the purchase agreement.

After this, the buyer’s earnest money is then deposited into the escrow account and held until key conditions are met, like getting the home professionally appraised, securing a mortgage loan, getting the home inspected, and more. Upon these conditions being successfully met, both parties are ready to close.

Once the sale of the home is underway, the funds in the buyer’s escrow account will be applied toward the down payment and closing costs of the home. After the transaction is complete, the agent managing the closing will release the earnest money and the escrow account is closed. This typical scenario highlights the importance of holding the funds to protect both buyer and seller until important conditions are met to allow the transaction to go through. If these conditions aren’t met, and the buyer must back out of the deal, their earnest money is refunded.

Because the escrow account is held by a third party, the hassle of trying to get earnest money back from the seller directly is eliminated. Alternatively, if seller-specific conditions aren’t met — like a buyer securing financing in a specific timeframe — they can relist their home on the market and pocket the earnest money without having to fight the buyer on it.

How Does Escrow Work for Homeowners?

On the flipside, once the buyer owns the home, they can open a mortgage escrow account through their mortgage lender. The escrow account they used to buy the home is only active until the transaction is complete, while a mortgage escrow account is active until the loan is fully repaid. In a homeownership scenario, the mortgage escrow account stores funds for the borrower’s key home expenses, like private mortgage insurance, property tax payments, and different insurance premiums.

These expenses are usually rolled into the monthly mortgage payment owed by the borrower. The mortgage lender will keep the funds in the mortgage escrow account to make these payments on behalf of the borrower. This helps mitigate the potential for the borrower missing any payments, helping further protect both parties.

Should a borrower skip out on paying their tax bills, the tax authority could end up putting a lien on the home, meaning they have a legal right to collect what is owed. In some circumstances, this could lead to foreclosure on the property, which ends up also costing the mortgage lender. Because mortgage lenders have a critical stake in ensuring the borrower is paying their property taxes and insurance, having a mortgage escrow account on the mortgage loan helps empower them to make sure these payments are made.

If you’re feeling ready to make a move on a property in your area, or simply explore your options as a prospective home buyer, it’s best to partner with a trusted, experienced real estate agent. They’re well-versed in the ins and outs of escrow as part of the buying process and beyond, and can walk you through key steps and provide insights on how it can impact the transaction overall. RealEstateAgents.com can help you connect with the top performing real estate agents in your local market. Get started today!