What Is an Escrow?

What Is Escrow?

Escrow refers to a neutral third party that is put in charge of holding something of value—usually cash—until a transaction between a buyer and seller is complete. The money is kept safe in an escrow bank account managed only by that third party. Think of escrow kind of like a referee in a football game. They take no sides and make sure everyone is playing by the rules until the game is over. But the name of the game here is real estate.

If you’re a home buyer or seller, being in escrow means different things:

• As a buyer, you agree to pay a percentage of the home price into escrow for safekeeping.
• As a seller, you agree to take the house off the market while it’s in escrow and make it available for inspections.

The main job of escrow is to ensure a fair and smooth real estate deal from beginning to end. You can use escrow accounts for other transactions like online shopping purchases (where the escrow service holds onto the money from the buyer until confirmation that the goods have been received). But right now we’re only dealing with escrow in real estate.

Types of Escrow Accounts

Remember, you’ll mainly use escrow as a money holder while making the biggest purchase in your lifetime—a house! But you’ll also use it after you close on your home too. Let’s unpack both scenarios.

1. Escrow Account for Home Buying

First, you’ll probably use an escrow bank account when you find your dream home and the seller accepts your offer. Here’s how that works:

• Agree on an escrow agent. Your real estate agent will probably recommend an escrow agent who both you and the seller agree on. This escrow agent could be a professional title agent, a real estate lawyer or a mortgage loan officer.
• Deposit earnest money. You’ll be asked to put down an earnest money deposit—a small percentage of the home sale price, which you’ll make payable to the escrow provider. They’ll hang on to your money until the sale is final. 

Earnest money acts kind of like a security deposit that shows the seller you’re serious about buying their house. In return, they agree to take the home off the market, make it available for inspections, and carry out any agreed-upon repairs or provide disclosures to help see the sale through. 

When you finally get to closing day, the earnest money will be subtracted from the amount you owe the seller and put toward closing costs. If for any reason the seller doesn’t make an agreed-upon repair by the closing date, then money can be held from them in escrow to cover the cost to you. And if the deal falls through? Don’t worry: You’ll get your earnest money back minus a small cancellation fee.

2. Escrow Account for Mortgage Payments

Okay, even after you purchase a house, most mortgage lenders will request you have an ongoing escrow account for taxes and insurance.

This escrow account will be in your name, containing money paid in by you, and accessed by your mortgage lender. Here’s how it works:

• Set up account. Your mortgage company sets up your escrow account after you’ve closed on your home.
• Make payments. Then, you pay into it every month as part of your monthly mortgage payment.

A homeowner escrow account isn’t the most exciting thing in the world because its only purpose is to give you one place to pay for expenses like home insurance and property taxes. But at least it means you won’t have to worry about paying for those separately on your own. Also, you’re usually required to keep two months’ worth of escrow expenses in your account at all times. That’s to make sure you’re covered if your tax or insurance bills increase unexpectedly.

How Does an Escrow Account Work?

Imagine it’s closing day for your house purchase. Yay! The champagne is on ice, and you’re signing the paperwork at your real estate attorney’s office. This is when you’ll get the breakdown of your monthly payment to the mortgage lender. 

To understand what’s included in your monthly mortgage payment, think of the acronym “PITI.” Here’s what that stands for:

• Principal
• Interest
• Taxes
• Insurance

Taxes and insurance are the parts of your monthly payment that will go into your escrow account and be held by your lender to pay property taxes and home insurance each year. The reason mortgage lenders want you to have an escrow account is so they don’t have to worry about you falling behind on these important expenses. In the end, you don’t want to lose your house, and they don’t want to lose the money they’ve just loaned to you! And like we pointed out, an escrow account is also helpful to you because you don’t need to stress about making sure your property taxes and home insurance are paid on time each year. The escrow account does that for you!

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