When you enter the home buying process, you likely have lots of questions about down payments, interest rates and closing day. You may wonder what you need to do to get a mortgage. You will need to learn about a concept called escrow as well.
Since most people deal with escrow infrequently, they typically need someone to guide them through the process. Escrow does not have to be complicated, especially when you work with an independent escrow company and an experienced Escrow Officer who can efficiently guide you through the process. Believe it or not, escrow represents a fundamental part of real estate transactions by protecting sellers as well!
Below, we detail how the escrow transaction works and why you need it when buying a home.
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.
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.
Why is Escrow Important?
Escrow is important for several reasons. First, it provides a level of protection for both the buyer and the seller in a transaction. The third-party escrow company ensures that the funds or assets are held securely and released only when certain conditions are met. This helps to prevent fraud and protects both parties from any potential scams or illegal activities.
Second, escrow can help to simplify complex transactions. When there are multiple parties involved in a transaction, or when there are numerous conditions that need to be met, using an escrow account can help to ensure that everything is handled smoothly and efficiently.
Finally, escrow can help to reduce the risk of disputes between the parties. By using a neutral third party to hold and distribute funds or assets, both parties can be assured that the transaction is being handled fairly and impartially.
Should You Use an Escrow Account?
Depending on the type of loan and its specifics, you might not have the option to forgo an escrow account. If you are applying for a conventional mortgage (one from a private bank or lender) an escrow account and mortgage insurance are often required. You also typically do not have a choice if you are getting a federally backed loan, either. FHA loans and USDA loans require escrow accounts, though VA loans do not.
But even if you did have a choice, there are viable reasons to have an escrow account. Purchasing a home might be one of your biggest financial decisions. Using an independent escrow company ensures your transaction and assets will be handled by a 100% neutral third party. An escrow account can be an easy, hassle-free way to make payments for your mortgage, homeowners and mortgage insurance and property taxes, and the cushion can help cover potential shortfalls. With escrow, you do not have to set aside the funds, including extra for any unforeseen increases in premiums or taxes, and then making sure you meet the due dates for payments.
Your escrow company is what safeguards your funds and documents while those funds and documents are in their possession. You also need escrow because they make sure all provisions of the escrow have been met in order for you to receive funds and/or convey title.
What Does Escrow Do For You?
Escrow’s primary job is to follow the instructions given by the principals and parties to the transaction. They handle the funds and/or documents, paying all bills as authorized and responding to requests from the principals. Escrow Officers can only close the escrow and distribute funds when all terms and conditions have been met.
Escrow can benefit all parties, from buyers to sellers to lenders. It is important to know the ways that escrow can help you during the home-buying process and after you purchase the home. Calculate how much you will have to pay as a homeowner for property taxes and insurance based on your particular home and location. Also calculate how much you might pay in escrow fees during the home-buying process.
What Escrow Does Not Do For You?
Escrow does not give real estate advice, legal advice, or act in the place of your Real Estate Agent or Broker. Most importantly, your escrow company does not email wiring instructions, ever. This is a gateway to fraud, and if you ever receive wiring instructions via email, call your Escrow Officer immediately from a business card or the number first given to you in your opening email, and contact your Real Estate Agent.
Escrow provides assurances for all major parties in a real estate transaction—the buyer, the seller, and the lender—that their interests, and their funds, are protected. Your escrow agent will track and verify the transfer of key variables such as the transfer of the property title from the seller to the buyer and the transfer of funds from the buyer to the seller. It also helps assure the lender that the loan money is going to the right place.
As a buyer, it can be intimidating to transfer thousands of dollars to a seller you have never met, or have met once, without knowing for sure that you would receive the title in return. And as a seller, it can feel risky handing over a title without a complete guarantee that the buyer is good for the purchase price. Escrow protections help give all parties peace of mind and help ensure that a real estate transaction goes through as easily as possible.
- How Buyers are Protected
The first way escrow is commonly used in real estate is to hold earnest money. This is a deposit made by a buyer after signing a purchase agreement, and it demonstrates a serious intention to buy.
Buyers also find protection in the fact that any repairs or problems found during the home inspection will need to be fixed before the seller receives the money for the purchase. The escrow process ensures that all conditions are met and that the deposit is safely stored without fear of a break in the agreed upon contract.
- How Sellers are Protected
Buyers find protection in the fact when buyers back out with no legitimate reason, they forfeit that money to the seller—a decent consolation for the sale’s failure and the expense of making mortgage payments and other expenses while the home was off the market.
- How Lenders are Protected
Another way escrow accounts are commonly used in real estate is by mortgage lenders. After a home sale is completed, rather than rely on the borrower to pay property taxes, mortgage insurance, and home insurance premiums on time, many lenders add the estimated costs into monthly mortgage payments. The mortgage servicer then deposits these “extra” funds into an escrow account and takes responsibility for paying the bills on time.
A Final Word
Your home purchase is one of the biggest investments you will make. Over the past century of buying and selling real estate in the United States, many processes have been put into place to protect the home-buying process, as well as your homeownership rights. The escrow account is an essential tool that offers protection to everyone in the process.
Whether you are the buyer, seller, lender, or borrower, you want the assurance that no funds or property will change hands until ALL of the instructions in the transaction have been followed. Your escrow company is what safeguards your funds and documents while those funds and documents are in their possession.