When buying a home, there are many steps and important tasks that must be undertaken prior to finalizing the transaction. Escrow is one of these steps. Escrow accounts are a secure way to manage the exchange of money and property between two parties. They are commonly used in real estate transactions, but can also be used for other types of transactions.
Borrowers who opt for a loan from USDA, VA Streamline Refinance or FHA, for example, must deposit funds into an escrow account as part of their monthly mortgage payment. Each month, the lender deposits the portion of the security deposit of your mortgage payment into the account and pays insurance premiums and real estate taxes when they are due.
Understanding how an escrow account works can help you make informed decisions when it comes to buying or selling property.
What Is Escrow?
Escrow acts as a neutral third party in a real estate transaction. Pre-closing, escrow’s job is to hold onto money during the transaction before agreed upon actions are completed on both sides. In the case of buying or selling a home, neither the buyer nor the seller has access to said money. Once all conditions are met in the transaction, escrow will make the funds available to close the deal.
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.
After your loan closes, you may have a mortgage escrow account which is a holding account for your property tax payments and homeowners insurance premiums. Your mortgage lender will collect these payments on a monthly basis as part of your mortgage payment, hold them in the account, and then pay the bills automatically on your behalf.
What is Escrow Used For?
Escrow is a neutral holding account for funds as well as a repository for critical documents involved in the process of selling and buying a home. An escrow agent can set up an account for you, which is usually done between 30 and 60 days before the closing date. This time is known as the “escrow period” and starts at the time that the contract is signed and usually ends with the closing when all fees, funds, and documents are transferred and signed.
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. Once a property sale agreement is made or a contract is signed, an escrow account is “opened.” The buyer deposits funds into this account, which are held within the account until all obligations like home inspections or financing approvals are met. If all goes well and the deal progresses past all contingencies, the funds are released to the seller typically at closing or funding. If not, funds may be returned to the buyer.
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.
Typically, the seller’s agent will open an escrow account with a local escrow company on behalf of the seller once the listing is agreed to in writing.
Benefits of Escrow
Escrow accounts come with a few advantages. Firstly, escrows are able to provide a safe and secure mode of routing cash flows for all parties. Secondly, an escrow account allows transactions to be customized to suit requirements of all the parties. Thirdly, top banks allow opening and operating multiple accounts for deals with waterfall mechanism. Fourthly, escrow banking comes with channel support.
Some mortgage lenders and certain types of home loans require borrowers to maintain these accounts for property tax bills and insurance payments (or T&I), which can make these costs more manageable. Here are a few advantages to having an escrow account when buying or owning a home:
Understanding real estate escrow becomes a lot easier once you understand its benefits. Escrow provides assurance 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; most notably, 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, would you feel comfortable transferring thousands of dollars to a seller you have never met without knowing for sure that you would receive the title in return? And as a seller, would you really want to take the risk of 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.
2. Taxes and Insurance
An escrow account (or an impound account), is a special account that holds the money owed for expenses like mortgage insurance premiums and property taxes. When tax bills are issued by the tax assessor’s office, usually between mid-October and early November, your mortgage company will use the funds in your escrow account to pay the bill. If the amount of the tax bill is greater than what is in the escrow account, your lender will come to you for an additional payment to make up the difference. If the tax bill is lower than what is in the account, your lender would owe you a refund or a credit towards the following year’s tax bill.
When a reduction in taxes is achieved through a property tax protest, the tax bill that is sent to your lender will reflect the lower amount. In other words, your mortgage company will be paying fewer taxes on your behalf as a result of the protest. This directly affects the amount of the shortage you need to cover through an additional payment or the amount of the refund or credit that is due to you. Finally, every mortgage company treats this situation in their own unique way, so it is best to contact your lender to help guide you through the remainder of the process.
Benefits of Escrow for Buyers
- If the sale falls through, the buyer may get their earnest money back.
- Earnest money is often applied to their down payment or closing costs.
- Mortgage escrows break insurance premiums and property taxes into monthly payments.
- A lender manages the mortgage escrow account on the homeowner’s behalf.
Benefits of Escrow for Sellers
- If the buyer does not uphold the purchase agreement, the seller could keep the earnest money.
- Escrow ensures that a property doesn’t change hands before the sale is complete.
Benefits of Escrow for Lenders
- Using the account ensures payments are made on time and reduces lending risks.
- Managing the account themselves may help avoid late fees or liens against the property.
Who Pays for Escrow Fees?
The escrow company providing these services will charge a fee for their valuable time and work on behalf of buying and selling parties. During the initial draft phase of the contract, the buyer and seller ordinarily negotiate an agreement as to how to handle the escrow fees. There are three options: The buyer can pay the entire fee, the seller can pay the entire fee, or the buyer and seller can split the cost and include it in a final closing fee amount.
Having a qualified escrow agent to facilitate the many tasks involved in selling, borrowing, clearing the title, inspecting the home and so many other duties can mean the difference between a relaxed, easy closing day or a chaotic closing. The likelihood of a simple, quick closing is much higher when a professional escrow company is involved.
What is an Escrow Overage?
Your lender will perform an annual examination of your escrow account to make sure it is collecting the correct amount of money for the anticipated expenditures on your taxes and insurance. This analysis determines if there may be an overage, meaning that your escrow account is projected to have more than the minimum balance required at its lowest point in a 12-month period.
If an overage is projected, an adjustment in your monthly payment will be made. If the overage is over $50, you will receive a reimbursement check. If the overage is less than $50, your monthly payment will be prorated.
What is an Escrow Shortage?
An escrow shortage refers to any time when your escrow balance falls below a minimum required level. This is when you do not have enough money in your escrow account to pay for all your escrow items, like taxes and insurance. If that is the case, you end up with a negative balance in your account and your mortgage lender will advance the difference between what is in your account and the amount that is due. You will end up paying this back when your next escrow analysis is conducted.
On the other hand, you could end up with an escrow surplus. This occurs when you paid more into your escrow account than you had to in the previous year. This most commonly occurs if your property value has gone down enough to change your tax assessment, or if you switched to a cheaper homeowners insurance policy.
The Bottom Line
Your real estate agent will oversee this entire escrow process, so don’t be too concerned if you don’t understand every detail; however, in any transaction where you’re putting so much on the line financially, it is a good idea to have at least a basic idea of what is going on so you will not get taken advantage of—or inadvertently lose your home.