What Is Escrow?
If you’re in the process of making any large purchases — especially a significant online purchase or a home — it’s important to know what escrow is. So, what is escrow? Well, it’s basically just one word in a long line of ominous-sounding financial terms which, if you dig deeper, are not that complicated. You’ll hear this term most often during the process of buying a home, but it can be applied to almost any situation where an item of value needs to be kept secure during a transaction.
Escrow is a process in which a buyer and seller enlist a neutral third party to oversee something of value until the transaction between that buyer and seller can be completed. That thing of value is most often money, but it could also be documents or some other type of asset.
How Does Escrow Work?
Putting something “in escrow” is just another way to ensure it is secure while another party meets their end of a deal you’ve both agreed to. It’s especially important as an added layer of security for complicated and high-value transactions.
For example, if you give your neighbor a signed check to buy his lawnmower, it’s possible that he’ll cash the check and never deliver what you purchased. If you enlist another neighbor whom you both trust to hold the check until the first neighbor delivers the lawnmower, you won’t have to worry about losing the money.
This process doesn’t just keep you safe; it keeps the neighbor selling the lawnmower safe as well. He won’t have to worry about missing out on his payment even though he delivered the mower.
Escrow works the same way in a real estate transaction, but instead of a neighbor, the third party is escrow agent. An escrow agent might be an attorney, notary or a real estate closing company. Any funds involved in the transaction are held in an escrow account.
For home buyers, it means the money you provide to purchase a home won’t go directly to the seller before you’ve finished the process of buying the home. Your money is held in an escrow account instead while you and the seller reach a closing agreement. This way, the seller can’t hold your payment as leverage, and you can inspect the real estate to ensure it’s what you’re expecting.
If you’re a seller, escrow means you don’t have to worry about signing over your home before it’s been paid for. Instead, everyone gets what they are owed at the same time.
Escrow isn’t just used for real estate transactions, though. As a concept, escrow can be applied to many different types of transactions in addition to real estate and property transactions.
Different Types of Escrow
Online sales and e-commerce
Also known as “Internet escrow,” this type of escrow applies the same concept of traditional escrow to Internet transactions. It is particularly useful for online auctions and person-to-person (P2P) transactions on platforms like eBay, where the two parties never meet in person. Most major e-commerce companies use Internet escrow services.
If you take out a mortgage, you may need to pay property taxes and monthly mortgage insurance payments (“T&I”) in addition to payments toward your loan principal and interest (“P&I”). For this, your lender may set up an escrow account. This account will hold the money you pay monthly and the lender will pay your taxes and insurance fees out of that account each year.
In legal settlements like class-action lawsuits, money may be held in escrow until it is ready to be distributed to plaintiffs. This ensures the defendant doesn’t have the responsibility of judging who should receive money and how it should be distributed.
What is an Escrow Account?
An escrow account is essentially a bank account that is controlled by a third party. In real estate, an escrow account is most often established so that homeowners can pay their annual property tax bills and mortgage insurance premiums in installments. This allows them to make these payments on those annual bills at the same time they pay their monthly mortgage loan payments.
Some lenders may require an escrow account as a condition of a loan. For example, many lenders require you to take out mortgage insurance and pay those costs into an escrow account if you are committing less than 20% of the total cost of your home as a down payment. If you’re committing 20% or more, you may not be required to pay into an escrow account, but the lender may charge a fee to waive it.
If you obtain a loan insured by the Federal Housing Administration (also known as an “FHA loan”), you will be required to use an escrow account.
How to get an Escrow Account
If you’re required to pay into an escrow account as a condition of your home loan, your lender or your real estate agent will usually set up the account for you or provide you with steps to do so.
Otherwise, your bank may have an escrow service, or you can search for escrow agents, escrow companies or title insurance companies and choose your best option — just work with your lender in doing so.
There are other instances where you may want to set up your own escrow account. For example, if you intend to rent your property to tenants, you may need to set up an escrow account for their rent payments and security deposits. In some states, your tenants may have a right to pay into an escrow account if they are having a dispute with you, their landlord.
Some people also create personal escrow accounts to help them manage their finances, but you can set this up simply by opening a savings account and linking it to your debit account.
Escrow Account Costs and Fees
Like anything in life, escrow accounts are not free. Thankfully, the fees associated with them aren’t especially high. Escrow agents will typically charge a fee of about 1% of the home sales price in a real estate transaction for holding money in escrow. Paying this fee may be the obligation of the buyer or seller, or the two parties may split it.
If you’re a homeowner paying monthly property taxes and mortgage insurance installments into an escrow account, you’ll be responsible for the fees.
The Bottom Line
Escrow is a common agreement between lenders and homeowners to ensure yearly property taxes and mortgage insurance payments are made on time. It also helps to guarantee every party lives up to their end of the bargain during a real estate transaction. Escrow can be applied to other transactions as well.
While escrow accounts do involve fees, they are not typically that expensive. They also serve an important purpose in keeping funds secure for both parties.