What is Escrow and How Does it Work?

Understanding escrow in real estate

During the course of the home buying journey, you’ll eventually come across the term escrow. For many first-time buyers, escrow is a new concept that may be confusing. There are multiple types of escrow accounts that homebuyers will encounter throughout the process, but by the end of this article, you’ll have an understanding of the different types used to purchase a property.

Simply put, escrow is an asset held by a third party for a specific purpose until the terms of a contractual agreement are met. Escrow is intended to make sure both the buyer and seller hold up their respective ends of the real estate contract.

Escrow for the buyer

When buying a home, the buyer typically has to come up with a specific sum of money to put into escrow. The buyer gives the funds to an escrow agent who holds the funds in an escrow account. These funds go toward the purchase of the house if everything goes according to plan. If the seller breaks the contract terms before closing or the buyer backs out for an acceptable reason, the money will be returned to the buyer.

Escrow for the seller

On the other hand, if a buyer decides to break the terms of the contract, the escrow funds typically go to the seller as compensation for their time and trouble. With money at stake, the buyer is incentivized to follow through with the deal.

How escrow works before you buy your home

Once a buyer finds a home and the seller agrees to accept the offer, the buyer signs a purchase agreement. Typically, the buyer is required to make an earnest money deposit within five days. The earnest money deposit is held in an escrow account until the sale is final. The total earnest money deposit is usually 1 to 2% of the purchase price.

Depending on where the sale is taking place, a real estate agent or title company acts as the escrow agent. The escrow agent is responsible for holding and disbursing the funds according to the contract. The money stays in escrow until closing, when the earnest money is applied to the down payment or other closing costs.

The escrow deposit shows the seller that the buyer is serious about purchasing the home. Contingencies in the purchase contract usually stipulate that the seller can back out if the mortgage application is rejected or a home inspection finds unforeseen problems with the house. In those cases, the seller should receive most of their deposit back. The seller is likely to keep the funds if the buyer backs out for another reason.

How escrow works with your mortgage lender

The other type of escrow account to know about during a real estate transaction is mortgage escrow, which serves a different purpose than the earnest money deposit.

Because the mortgage lender is relying on the value of the property to serve as collateral in case the borrower defaults, they have a vested interest in making sure local property taxes are paid and that the home is properly insured in the event of a catastrophe. For this reason, escrow is a common feature of most mortgages. With mortgage escrow, the lender collects an additional escrow payment along with each mortgage payment. The payments go into an escrow account, which the lender uses to pay home insurance premiums and property tax payments on the homeowner’s behalf.

Each month the borrower can expect to pay 1/12 of the annual home insurance premium and 1/12 of the estimated annual property tax bill. The mortgage lender adjusts these amounts as needed, for example, if the buyer’s property taxes go up.

How escrow works at closing

At closing, the escrow agent applies the escrow funds toward the down payment or other closing costs required to complete the transaction. There are some scenarios in which the buyer could receive all or part of earnest money back. For example, there might not be a down payment required if the buyer secured a Veteran Affairs or Department of Agriculture loan. Additionally, the seller might agree to cover closing costs. Whatever portion of the escrow deposit that isn’t needed at closing goes back to the buyer.

If there is a mortgage escrow in effect, it needs to be funded at closing as well. The closing escrow payment is required to cover the next upcoming insurance and tax bill, as well as serve as a reserve that covers two months of expected tax and insurance payments.

Understanding escrow accounts

The term escrow by itself refers to the cash or other collateral that’s held in custody of a third party until the terms of a contract are fulfilled. The escrow account is the bank account used by the custodian to secure the escrow. Escrow can also be used as a verb, as in, “The earnest money will be escrowed until the deal is final.”

The use of a separate account prevents the escrow agent from commingling funds with their personal money or with funds from other buyers. Commingling funds is not only unethical, but highly illegal.

With mortgage escrow, having a separate account clearly distinguishes escrow payments as separate from mortgage and interest payments. Even if your lender doesn’t require you to have an escrow account, the Consumer Financial Protection Bureau recommends requesting one so that it’s easier to manage the large annual payments that come with property taxes and home insurance.

Am I required to have an escrow account?

There is no law requiring sellers to demand an earnest money deposit placed in escrow, but it’s a universally accepted practice and every buyer should be prepared to have earnest money funds at the ready. As for mortgage escrow, that isn’t required either. But borrowers get the best loan terms by agreeing to have a mortgage escrow account. In most cases, borrowers have to put down more than 20% and possibly pay a fee to avoid having a mortgage escrow account.

How do I choose an escrow holder?

It’s often up to the buyer to choose an escrow agent, but the seller must mutually agree. In most cases, the buyer’s real estate agent can help choose the escrow holder. Be certain to check the credentials of any potential escrow agent, and in no circumstances should a buyer give earnest money directly to a seller.

What is an escrow refund?

The term escrow refund applies to mortgage escrow accounts. This happens when the mortgage company collects more money than needed from the borrower for escrow purposes, resulting in a surplus. If the surplus is more than $50, the lender is required to send the borrower a refund. Borrowers are also due a refund for any remaining balance when the loan is paid off.

What does a holdback of funds mean with regards to escrow?

An escrow holdback is a different type of escrow account that applies to properties requiring repairs that the seller has agreed to complete. If the closing date arrives and the repairs aren’t complete, the buyer may be able to hold back a portion of the purchase price in an escrow account to ensure that the repairs are complete. That way, if the repairs aren’t completed, the seller forgoes the full purchase price. There are limits and complex rules surrounding escrow holdbacks that buyers should learn if they think they might end up in that type of situation.

The bottom line on escrow

Escrow is a valuable tool that protects both buyers and sellers in real estate transactions. Escrow also protects mortgage lenders from irresponsible borrowers. Whether it’s earnest money or mortgage escrow, the money that you put into those accounts is applied on your behalf in order to fulfill your legal obligations.

Frequently Asked Questions

What is the escrow part of the mortgage payment?
Mortgage escrow is used by your lender to pay taxes and insurance on your behalf. The escrow part of your mortgage payment consists of 1/12 of your estimated tax bill and 1/12 of your annual insurance premium.

What happens to money put into escrow during a home purchase?
The buyer’s earnest money that goes into escrow is applied to the closing costs or down payment at closing. Any surplus money goes back to them.

What happens to escrow if the buyer backs out?
A buyer forfeits the escrow deposit if they cancel a purchase agreement without cause. In such cases, the escrow deposit goes to the seller. A buyer is entitled to a refund under certain contingencies if they’re part of the purchase agreement, such as having their loan fall through or pending the outcome of a home inspection report.