Escrow, by definition, is a “bond, deed, or other document kept in the custody of a third party and taking effect only when a specified condition has been fulfilled”. Related to your finances, an escrow account is an account used by a financial institution to temporarily hold funds until they are due to another party. An escrow account commonly comes into play when buying a home or taking out a mortgage.
To simplify the concept of an escrow, think about it related to selling an item overseas. A U.S. company is selling customized steel to an overseas customer, but the customer does not want to pay for the steel until it has been inspected locally. To protect both parties, an escrow account is established with a trusted third party, and the money for the steel purchase goes into it. In other words, the funds are placed “in escrow” until the customer accepts the steel. The third-party escrow agent will then release the funds to the U.S. company. This can help protect both the importer and exporter from fraud, and can prevent arguments about whether payment should be made before or after an item ships.
So how exactly does an escrow account come into play when buying a home? Let’s take a closer look:
What is an escrow agent?
In the case of home buying, an escrow agent is the financial institution that serves as the intermediary between the buyer and seller. The escrow agent essentially sets up a bank account to hold the initial offer that the buyer puts down on the home and keeps it there until all contractual obligations are met. In the case of a mortgage, an escrow agent is the financial institution that holds a portion of the borrower’s mortgage payments in an account until the funds are ready to be paid out for the borrower’s property taxes and homeowner’s insurance.
When a bank accepts the role of escrow agent on behalf of a home buyer or borrower, they acquire a fiduciary responsibility to see that the terms of the agreement are met before funds are released. An escrow agent is also responsible for ensuring that all paperwork, forms, and declarations are processed correctly.
Why are escrow accounts used?
Here are some common uses for escrow accounts in the home buying process:
• Purchasing a home. When an offer on a house is accepted, the buyer must typically put the funds – commonly referred to as “earnest money” - in an escrow account, indicating a commitment to buy. While the funds are in escrow, the appraisal, home inspection, title search, and agreed-upon repairs are usually completed. The buyer cannot occupy the property during this time. During the closing, the escrow amount is paid to the seller as part of the sale price.
• Taking out a mortgage. If the borrower is using a mortgage to purchase the home, an escrow account will typically be established by the lender to hold funds for property taxes and homeowner’s insurance. These estimated amounts are incorporated into the borrower’s monthly mortgage payment. When the payments are received each month, the amounts earmarked for escrow are deposited into the escrow account. Often, the amount of escrow payments fluctuate throughout the life of the loan as property taxes and insurance premiums go up and down. Each year, your lender will complete an escrow analysis to determine if the correct amounts are being collected with each mortgage payment. If the escrow balance is too high, you might receive an escrow refund, or your monthly mortgage payment might go down. If your escrow balance is too small to cover the property taxes and insurance, you may be given the option of making a lump-sum payment to cover the shortage, or your monthly mortgage payments could increase.
What are the pros and cons of an escrow account?
An escrow account protects both the buyer and seller during a real estate transaction. It prevents the buyer from rescinding the offer (if they do, they will typically lose the earnest money deposited into the escrow account) and ensures that all contractual obligations are met before the money is released to the seller.
With a mortgage, an escrow account prevents the borrower from having to scramble to make a lump-sum property tax payment or pay an annual insurance premium all at once. An escrow account ensures the borrower is saving for those large expenses throughout the year. This helps to guarantee that the home is insured, and that a lien is not placed on it for non-payment of property taxes. It provides peace of mind for all parties involved.