When buying a home, you’ll probably hear your lender or real estate agent use the word escrow. Escrow is an essential part of any real estate transaction. Even so, many homebuyers and homeowners remain unfamiliar with escrow and how it works.
The term “escrow” can describe a few different functions from the time your offer is accepted to the day you close on your home. Escrow protects homebuyers, sellers, homeowners, and even lenders with real estate-related financing. In fact, escrow still plays a role after you have become a homeowner with a mortgage.
When buying a home, your escrow provider is a valuable member of your team. However, many home buyers and sellers can’t answer the question “what is escrow?” or explain how it works.
What is Escrow?
Escrow refers to a third-party service that is part of every home purchase. When a buyer and seller initially arrive at a purchase agreement, they select a neutral third party to act as the escrow agent. The escrow agent collects a deposit from the buyer that is equal to a small percentage of the sale price. This deposit is known as “earnest money”. In exchange, the seller takes the property listing off the market. Until the final exchange is completed, both the seller’s property and the buyer’s deposit are said to be in escrow.
How Does Escrow Work?
Escrow accounts are a part of the mortgage process homebuyers typically cannot avoid. With mortgages, home buyers typically pay a little extra into an escrow account every month, along with their home loan payments.
While a mortgage holder (most typically a bank) collects the principal and interest payments each month, they also can collect homeowner’s insurance payments and property taxes. They will then pay those bills when they come due. They do this because when you borrow money from a lender to finance your home purchase, the property becomes the collateral for your loan. Your lender needs to know that the property is adequately insured so that it can be repaired or replaced if damaged. Likewise, they want to prevent a tax lien being placed on the property if you neglect to pay taxes.
Benefits of Using Escrow
The biggest benefit of having an escrow account is that it ensures that the funds being exchanged are secure and that they will only be released once all the conditions of the agreement have been met. This provides added security and peace of mind for both parties.
It can also protect you as a homeowner, ensuring you have the money to pay for property taxes and homeowners’ insurance when the bills arrive. You will find that there are a few other great benefits for home buyers, owners and lenders, too.
- For Home Buyers
An escrow account is key to protecting your deposit during a home sale. For instance, if the sale falls through due to a problem found during the home inspection, you are more likely to get your deposit back if the money is held by a third party than if your deposit went directly to the seller.
- For Homeowners
An escrow account takes the pressure off the homeowner to come up with a lump sum to cover taxes and insurance. Since you are paying for your taxes and insurance throughout the year, the payments are much more manageable. You also do not have to keep track of all the different due dates. When your tax bills and insurance premiums are due, your mortgage servicer will make sure those bills are paid on time, every time. No more late payments. Your servicer will even cover bills for you if your escrow account is short on funds.
- For Lenders
Lenders have a vested interest in making sure your property taxes and insurance get paid:
- If your tax bills do not get paid, the tax authority could put a lien on your home – which could end up costing the lender money if the tax authority chooses to foreclose.
- If your homeowner’s insurance coverage lapses, significant damage to or loss of the home could lead to extreme loss of value of the home.
How Escrow Protects the Buyer
When buying a home, you want to ensure that your investment is protected. That is where escrow comes in. When buying a home, your purchase agreement will usually include a good faith deposit (also known as earnest money). This deposit shows that you are serious about purchasing the home. If the contract falls through due to the fault of the buyer, the seller usually gets to keep the money. If the home purchase is successful, the deposit will be applied to the buyer’s down payment.
In a real estate transaction, the escrow agent is a neutral third party who holds and safeguards the deposit money until all the conditions of sale are met. Here’s how escrow protects buyers in a real estate transaction.
- Your Deposit is Protected
Escrow protects buyers by holding the deposit money paid at closing. Once that money is deposited into escrow, it is typically non-refundable (unless both parties agree to cancel the transaction). This protects buyers if the seller backs out of the deal or fails to meet other agreed-upon conditions, such as making necessary repairs before closing.
- All Conditions of Sale Will be Met
If you are in the process of buying a home, you have probably gone through the escrow process. Escrow is a term used in real estate to describe the holding of money and documents by a third party until all conditions of the sale have been met. If for some reason the escrow doesn’t close on time, there are a few things that could happen. This article will discuss what could happen if escrow doesn’t close on time and how you can protect yourself.
- All Paperwork Will be Handled by a Professional
Being “in escrow” basically means “drowning in paperwork,” or at least it can feel that way sometimes. From disclosure forms to inspection reports and insurance information, there are a lot of things to keep track of. Your escrow officer and real estate agent will be a tremendous resource here, letting you know what needs to be completed and when. It’s your job to hold up your end of the partnership and get everything completed in a timely manner.
How Escrow Protects the Seller
- Peace of Mind
Having a neutral third party to hold onto the important documents and all the money allows you to know that as long as you do your part and the other party does theirs, the end will result in what you had planned for. Without having an escrow account and a neutral third party, you are relying upon the other person to be true to their promises and that is a dangerous assumption to have when it comes to business.
- Reduced Risk
Some real estate transactions naturally present more risk to the seller. If you need to engage in long-distance selling, you are exposing yourself to certain risks. Even when you sell to a local party, you are still going to be dealing with someone you don’t know, in most cases.
- Financial Security
One of the main advantages of using an escrow service is that it provides a high level of security for both parties. The funds are held by a neutral third party, which reduces the risk of fraud or other issues that can arise in financial transactions. As the Seller, you are also protected from any unexpected chargebacks, thereby ensuring that you will not fall prey to a scam.
5 Tips for Successful Escrow Transactions
Using an escrow service can help to ensure that your transactions are secure and completed as expected. Here are some tips for successful escrow transactions, and you can read more about how to make the process less stressful here:
- Make sure to read the escrow contract carefully and understand the terms and conditions before signing.
- Make sure to provide all the necessary paperwork and information to the escrow service in a timely manner.
- Make sure to monitor the progress of the transaction and verify that all the conditions of the agreement have been met.
- Make sure to keep all documents related to the transaction in a safe place.
- If there are any issues or disputes, make sure to contact the escrow service immediately.
Escrow services provide a high level of security and protection for both buyers and sellers in financial transactions. By holding funds until all of the conditions of the transaction have been met, escrow agents help to ensure that both parties are protected, and that the transaction is completed efficiently and transparently. Whether you are buying a home, purchasing goods online, or engaging in a complex business transaction, escrow services can provide peace of mind and help to ensure a successful outcome.