Marcio Vasconcelos
When navigating the world of real estate, the term "escrow" often comes up, and it can be a bit confusing for those not familiar with the process. If you are about to buy or sell a house, understanding this term and its applications is a fundamental tool to avoiding further confusion. “What does escrow mean in real estate?”, “How does it work?” “Who does escrow benefit?”. Without further ado, let’s answer these questions!
What Does Escrow Mean in Real Estate, and how does it work?
In the simplest terms, escrow refers to a financial arrangement where a third party holds and regulates the payment of funds required for two parties involved in a transaction. When it comes to buying a house, escrow is crucial.
It starts when a buyer makes an offer on a house, and the seller accepts it. At this point, the buyer puts a deposit into an escrow account to show their good faith in proceeding with the purchase.
The escrow account then acts as a neutral holding place for the deposit, and later, for the funds necessary to complete the sale. It ensures that no funds or property will change hands until all terms of the agreement, like home inspections, mortgage approvals, and other contingencies, have been met.
Who Owns the Money in an Escrow Account?
The money in an escrow account is technically owned by the person who deposits it, but its use is strictly regulated. Until the completion of the real estate transaction, the money can't be accessed by either the buyer or the seller. The escrow agent, who oversees the account, ensures that the funds are used only for their intended purpose.
This arrangement helps protect both parties involved in the transaction. If the contract is terminated because of the buyer's error, the seller typically retains the deposit. Conversely, if the home purchase is completed, the deposit is credited towards the buyer’s initial payment.
Types of Escrow Accounts Explained
Primarily, escrow accounts play a pivotal role in the most significant purchase you might make in your life - buying a home. Additionally, their use extends beyond the closure of your home purchase. Let’s explore both these situations:
1. Escrow in Home Purchasing
When you set your sights on your ideal home and your offer is accepted by the seller, you’ll likely engage with an escrow bank account. Here’s the process:
Selecting an Escrow Agent
Usually, your real estate agent will suggest an escrow agent agreed upon by both you and the seller. This agent could be a title professional, a real estate attorney, or a mortgage officer.
Depositing Earnest Money
You’re required to deposit a small portion of the home’s sale price as earnest money with the escrow provider. This deposit acts as a sign of your commitment to the purchase. In exchange, the seller agrees to withdraw the home from the market, allowing for inspections, and agrees to undertake any repairs or disclosures necessary to facilitate the sale.
On closing day, your earnest money is deducted from the total amount you owe to the seller and is applied towards closing costs.
If the seller fails to complete a repair by the closing date, funds may be withheld from them in escrow to compensate you. And if the transaction doesn’t proceed? You’ll receive your earnest money back, less a nominal cancellation fee.
2. Mortgage Payment Escrow Account
Post-purchase of a house, it's common for mortgage lenders to require an escrow account dedicated to taxes and insurance. This account, under your name, is funded by you and managed by your mortgage lender. Here's the breakdown:
Account Setup
After closing on your home, your mortgage company will establish your escrow account.
Monthly Contributions
You contribute to this account as a part of your regular mortgage payment.
While a homeowner escrow account might not be thrilling, its main function is to consolidate payments for things like home insurance and property taxes into one place. This spares you the hassle of handling these payments individually.
Furthermore, you're typically expected to maintain a reserve equivalent to two months' worth of escrow payments in your account. This precaution ensures you have sufficient funds to cover any unforeseen increases in tax or insurance costs.
What Does an Escrow Account Mean?
Essentially, an escrow account is one that you contribute to monthly. The funds in this account are then utilized to cover costs like taxes and insurance on your behalf when they come due. Owning a home brings with it extra financial obligations, such as property taxes and insurance.
Escrow accounts are a useful tool to prepare for these expenses, ensuring that funds are allocated specifically for these purposes so you don’t have to worry about them. The homeowner pays into this escrow account monthly, along with their mortgage payment. The lender then uses these funds to pay the bills on behalf of the homeowner when they come due.
How are escrow payments calculated?
Escrow payments are calculated based on the annual costs of property taxes, homeowners insurance, and possibly other items like homeowners association (HOA) fees or private mortgage insurance (PMI).
To clarify, suppose the annual property taxes are $2,400, the homeowners insurance premium is $1,200, and there are no other fees. The total annual amount needed in escrow would be $2,400 (taxes) + $1,200 (insurance) = $3,600. The monthly escrow payment would be $3,600 ÷ 12 = $300.
Who Manages An Escrow Account?
An escrow account is typically managed by a neutral third party. The specific entity responsible for managing an escrow account can vary depending on the context and the stage of the transaction. Common managers of escrow accounts include:
Escrow Companies
Specialized firms that handle escrow accounts, particularly in real estate transactions. They ensure that all the conditions of the sale are met before disbursing funds.
Escrow Agents
These can be individuals or companies with expertise in handling escrow accounts. They act as the intermediary between the buyer and seller, managing the funds and documents involved in the transaction.
Mortgage Servicers
In the context of home mortgages, mortgage servicers often manage escrow accounts for property taxes and homeowners' insurance. They collect a portion of these expenses along with the monthly mortgage payment and disburse them when due.
Title Companies
In real estate, title companies often serve as escrow agents, holding and managing funds during the property transaction process until the deal is closed and the title is transferred.
Attorneys
In some cases, particularly in legal settlements or certain types of real estate transactions, attorneys may manage escrow accounts.
Banks or Financial Institutions
Some banks offer escrow account services, particularly for their customers engaging in large or complex transactions.
People also ask
With which frequency do I make escrow payments?
As long as you have an outstanding mortgage, you will contribute to your escrow account monthly. It's important to note that a portion of your monthly mortgage payment, which covers property taxes and homeowners insurance, is allocated to this escrow account.
Once you've made your final mortgage payment and your house is fully paid off, you'll still have obligations for property taxes and home insurance. However, without a mortgage, these payments will be made directly by you to your local tax authority and insurance company, rather than through the escrow account.
What are the advantages of having an escrow account?
An escrow account brings many advantages for all involved in the real estate transaction. Let’s analyze them:
For Home Buyers
Protection for Your Deposit - An escrow account safeguards your deposit in a home sale. For instance, if a sale doesn't go through due to issues found during an inspection, your deposit remains safe. Without an escrow account, retrieving your deposit directly from the seller might be challenging.
For Homeowners
Ease of Payment - Escrow accounts distribute the burden of large lump-sum payments for taxes and insurance throughout the year, making them more manageable. The account also simplifies the homeowners finances by tracking and paying your tax and insurance bills on time, preventing late fees.
For Lenders
Securing Payments: Lenders benefit from the use of escrow accounts to ensure property taxes and homeowners insurance are paid. Unpaid taxes could lead to a lien on the property, potentially costing the lender in the event of a foreclosure.
It goes without saying that if f insurance lapses and the home suffers significant damage, it could drastically reduce the property's value.
What are the disadvantages of having an escrow account?
While there aren't significant downsides to having a mortgage escrow account, some aspects might be seen as less favorable:
Integrated Costs
Including escrow in your monthly mortgage payment means a higher total payment. However, this approach spares you from making large, one-time payments for taxes or insurance, which can be seen as a benefit rather than a disadvantage.
Fluctuating Property Taxes and Insurance
The escrow amount is based on the previous year's property taxes and insurance costs, which can vary annually. For example, tax reassessments following a move can lead to a substantial increase in property taxes, particularly if the home's value has risen.
Adjustments for Shortfalls
If the initial escrow estimate falls short, you will need to cover the difference, resulting in a higher monthly escrow payment. Conversely, if your escrow has surplus funds after paying taxes and insurance, you'll receive a refund from your servicer.
Yearly Reassessment
Each year, your escrow is reviewed, and your monthly payment may be adjusted. If the previous year’s funds were insufficient, your payment will increase to prevent future shortfalls. If there was an excess, your monthly payment might decrease, and you might get a refund.
Can I avoid having an escrow account?
It’s more likely that you can not avoid an escrow account as most mortgage lenders require it. However, in the rare instances where opting out is possible, the process can be quite complex and involves several steps.
Different lenders have their own policies, but generally, you might need to hold your mortgage for at least one year without any late payments. Following this, you would need to formally request, in writing, to waive the escrow requirement. Additionally, you must annually provide documented evidence that you’ve timely paid your property taxes and home insurance.
What escrow accounts don’t cover?
Escrow accounts are primarily designed to cover property taxes and homeowners insurance, but there are several expenses they typically don't cover.
These include homeowners association (HOA) fees, supplemental tax bills, utility payments, and maintenance costs. In some cases, special assessments or certain types of insurance like flood insurance might also not be included. Homeowners are responsible for these expenses outside of their escrow arrangement, meaning they need to plan and budget for these costs separately.
