If you've been thinking about buying a home, you have probably heard the phrase "escrow" before. However, until you've been through the process, this term can feel a bit vague and hard to understand. To that end, we've created a guide on escrow. Keep reading to learn what escrow is and how it is used in a real estate context. Armed with this knowledge, you'll have a much better idea of how your money will be handled.
What is escrow?
By definition, escrow is a legal arrangement in which money is held by a neutral third party until the two parties involved in the transaction complete their contractual obligations. An escrow agreement is typically used in situations where there is uncertainty whether one party in the transaction will fulfill their obligations.
An escrow fund can be used in a variety of contexts, including business mergers and acquisitions, intellectual property agreements, and banking transactions. However, in this case, we are looking at it from a real estate financing context.
What are the different types of escrow?
Before diving into the particulars of the escrow process, it's important to understand that escrow is used in two separate ways in the real estate industry. We've gone into more detail about each of these types of escrow accounts below. Read them over so that you have a better idea of how your funds will be affected.
An escrow account in a real estate transaction
The first time you'll encounter an escrow fund will be drawing the homebuying process. Your purchase agreement will specify that your earnest money deposit should be held in an escrow account. This ensures that the money will go to the correct party, depending on how the transaction ends up.
If the buyer follows through with purchasing the home, the escrow provider will ensure that the earnest money is applied to the down payment. However, if the buyer breaches the agreement, the escrow provider will ensure that the seller is able to keep the deposit money for their trouble. In addition, after the inspection results have been shared, an escrow holdback may be negotiated, which allows the buyers to put money toward necessary repairs after your real estate closing.
In most states, someone from the title company will typically serve as the escrow officer, in addition to doing the title searches and providing title insurance. As mentioned above, they will distribute any funds held in the account according to the escrow instructions in the purchase agreement. However, if you live in an attorney state, one of the attorneys involved in your transaction may serve as the escrow holder instead.
A mortgage escrow account
The second type of escrow fund you'll encounter is a mortgage escrow account. With mortgage escrow, your lender or mortgage servicer serves as the escrow holder. In this case, they will take a portion of your monthly mortgage payment and hold it in an escrow account until certain payments are due. Then, when they come due, your mortgage lender will pay them on your behalf.
Typically, funds for recurring payments, such as your property taxes, homeowners insurance, and mortgage insurance are held in one of these accounts. In some cases, having a mortgage escrow account is optional. Still, lenders usually require it for new homeowners and those with high loan-to-value ratios.
If you have a mortgage escrow account, your lender will also do an escrow analysis each year in order to determine whether the right amount of disbursements were held in your escrow account for taxes and insurance. If too much was held in the past year, you will likely get a refund. However, if not enough was put away, you will have an escrow shortage. Typically, a shortage is recovered by prorating the payment for the shortage amount over the year.