Escrow is a financial account held by a third party on behalf of two other parties engaged in a transaction. The money is held until certain terms of the agreement — such as buying a home — are finalized.
With real estate deals, you’ll encounter options to use escrow at two points — once when you’re buying the home and again with your mortgage payments. When deciding to use escrow for either of these transactions, it’s important to know how it can protect you and what the downsides are.
- Escrow uses a neutral third party to protect the interests of both buyers and sellers during a transaction.
- Escrow can also be a third-party account meant to hold funds until meeting the contract terms or to pay the property taxes and insurance on a property you own.
- Use of an escrow account is required on government-backed mortgages and conventional mortgages with less than 20% down.
How escrow is used
Whether you realize it or not, you’ve likely used an escrow when putting down the security deposit on a new apartment, selling an item online, or buying a home. In these situations, escrow is a holding account to securely house funds associated with a sale.
An impartial third party maintains the account, which protects the interests of both the buyer and seller. Once the buyer and seller meet the terms of their agreement, the money gets released to the seller. If terms aren’t met, the money could be refunded to the buyer.
Escrow could also have a different meaning. When buying a home, or conducting a business merger or acquisition, escrow also refers to a legal agreement employing a third party.
The exchange of documentation and money goes through a neutral escrow service which promotes transparency between the buyer and seller while again, protecting the interests of both. It helps avoid payment disputes and ensures the smooth transfer of money, contracts, and assets.
How does escrow work?
In real estate transactions, escrow takes place when buying or selling a home and when paying your mortgage. Both of those scenarios use escrow differently.
For a home purchase
During a home purchase, escrow accounts store the earnest money deposit from the buyer. An earnest money deposit (also known as a good faith or escrow deposit) is an agreed-upon amount from the buyer proving their commitment to the deal. It’s usually 1% to 2% of the purchase price and compensates the seller if the buyer exits the sale without a legitimate reason.
If the contract goes to closing, the earnest money goes toward the overall closing costs.
This deposit protects the seller from the added costs of putting the home back on the market after the sale falls through. Buyers are also protected since sellers must meet contingencies listed in the sales contract before they see any money.
For example, if the buyer and seller agreed to a home inspection contingency and the basement flooded during a final walkthrough, the seller would need to fix the issues with the basement before receiving payment from the escrow.
For a mortgage
If you’ve made less than a 20% down payment on a conventional mortgage or decided to go with a government-backed USDA or FHA loan, escrow accounts are required. It stores the portion of your mortgage paying for property taxes and insurance on your home. Here’s how it works:
- Your lender calculates annual property taxes and insurance payments on your home and divides it equally across your mortgage payments for the year.
- You review a breakdown of those costs in the closing disclosures before you sign and finalize the home purchase.
- As you pay your mortgage, the escrow collects the predetermined amount in an account and pays your taxes and home insurance on the due dates.
- If the amount of your taxes or insurance undercuts what you’ve paid, your mortgage company will issue a refund for the difference. The opposite can also happen where you receive a bill for the remainder of the cost.
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Escrow pros and cons
Although there are plenty of benefits to using escrow in real estate transactions, there are also some downsides to consider if you have the choice of whether or not to use one.
Pros:
- Protection from potentially shady sellers. If you were to give your earnest money directly to the home seller, there’s no guarantee that they wouldn’t take the money and run. By storing your money “in escrow” you’re protecting your money.
- Your mortgage lender pays two bills on your behalf. By paying your mortgage with escrow attached, you’re leaving the bill payments up to your mortgage lender instead of paying them yourself.
- Safeguard against tax liens. Since property taxes are automatically paid with the money held in escrow under your mortgage lender, it reduces the risk of missing crucial tax payments on your home.
Cons:
- Increased monthly payment. Adding escrow to your mortgage payment means a larger payment than just a mortgage alone.
- Causes payment fluctuations. The escrow amount could change throughout your loan repayment due to shifts in property tax amounts, insurance premiums, or due to regular cost analysis. This could create fluctuation in your monthly payment which makes it harder to budget.
- Loss of control. Escrow takes tasks off your plate, but it could also reduce the control you have over your money by reserving it before it’s needed to pay tax and insurance bills. If you were planning to use those funds for other purposes, you may need to weigh the costs and benefits of using escrow.
- Inaccurate payment estimates. Your loan servicer makes their best estimate of how much you’ll need to pay in escrow to cover included costs. However, it’s still only an estimate, so it could over or underestimate the amount needed. In an overestimate, you’ve paid too much and have lost potential gains (interest or otherwise) on that money even though you’re refunded for the overage. With an estimate below the true payment amount, you could be faced with an unexpected tax or insurance bill.
Bottom line
Overall, escrow is a choice that could save you time and trouble in paying the more irregular bills on your home. It also acts as protection during the process of buying or selling a home without showing favor to the buyer or seller since the process is managed by a third party.
