Understanding What Escrow is and How it Works

As a homebuyer, there are actually two different times you’ll be dealing with escrow. The first takes place during the home buying process. Escrow starts with your purchase offer on a home and ends when you close on the house. The second escrow period kicks in once you’re a homeowner. This is a contractual agreement that begins after you close on your home and ends once you’ve paid off your mortgage or refinance with another lender. We’ll take a look at both types of escrow and how they work below. 

What is escrow?

Escrow is a legal term that dates back centuries. It means a deed, deposit, fund, or property that’s held in the custody of a neutral third party, to take effect only when a certain condition has been fulfilled. This third party’s responsibility is to oversee the transfer of ownership from seller to buyer according to the terms of the contract of sale. 

Why are escrow accounts used?

Escrow benefits the homebuyer by making sure the seller fulfills all the conditions of the sale, such as any repairs they agreed to make. It also benefits the seller in case the buyer pulls out of the deal without a contractual basis to do so, in which case the seller would get to keep the earnest money deposit. 

An escrow account also simplifies the closing transaction, since it provides a central location where all of the funds are received and then paid out from.

How does escrow work during the home buying process?

When you make an offer to buy a home, you normally put up what’s called earnest money to show the seller that you have a serious offer and are ready to complete the purchase. Once the seller accepts your offer, the agent drafts a written contract of sale with all of the details, including the price and the timeframe for closing. 

When you and the seller sign the contract, you put down a deposit. The earnest money and any additional deposit are held in a special account called an escrow account, maintained by an escrow agent. The money stays in this escrow account until all conditions of the sale have been met by both buyer and seller. The escrow agent is typically a title company, a bank, or a separate escrow firm. Though you’re free to select an escrow agent yourself, your real estate agent or bank can often recommend one. 

Why escrow is important

To get comfortable with the concept, think about where the money would be held if there weren’t escrow accounts. Who would hold each party responsible to fulfill the conditions of the sale? The escrow agent facilitates the sale. They hold the title and money until all conditions of the sale are met. For example, say the home inspection uncovered a significant problem, and the seller agreed to get it repaired. At the final walk-through, you discover that the seller hasn’t made the repair yet. You may be able to delay closing until the repair is made, meaning the seller won’t be getting the sale proceeds until they fulfill that condition. 

What is the escrow process?

After you and the seller negotiate the sale contract, the title company runs a title search to check the home’s title history. The goal is to make sure the home’s title doesn’t have any encumbrances, such as undisclosed mortgages, liens, missing heirs, eminent domain, or adverse possession. The typical home sale contract requires a marketable title that has no encumbrances. Lenders often require a lender’s title insurance policy, but this protects only the lender. You can also purchase owner’s title insurance to protect your interests against past events (not future events, like with other types of insurance), in case a defect in title is later discovered.

This home buying escrow period ends when you close on the house. Closing can also be called closing of escrow. The escrow agent will arrange the closing process, including presenting the purchase and sale agreement, lender instructions, buyer and seller instructions, and other documents for the parties to sign.

The closing also includes the payment of service fees for the escrow agent. These can range from hundreds to thousands of dollars, depending on the sale. The service fees should be listed in the loan estimate you get from your lender before closing and could change until you receive the Closing Disclosure from your lender.  

The escrow agent will transfer the deed to you as the buyer (or in some cases, to a trustee who holds title during the term of your mortgage), while the purchase money is transferred to the seller, completing your purchase of the home. The costs of escrow, including lender closing fees and title insurance, will typically be about 1-2% of the value of your new home.

As part of the escrow process, you’ll typically be depositing funds to cover 3-12 months worth of property taxes and insurance. Depending on your title company and lender, these may be shown as payments to be made at closing to your insurance company and local tax collector. Or they may appear as a pre-payment toward your lender escrow account, or a combination of the two. 

How does escrow work once you’re a homeowner?

This type of escrow account is established and held by your mortgage lender, who uses it to pay certain property expenses on your behalf. These expenses are mainly property taxes and homeowner’s insurance. Your lender will estimate the total annual expenses that will need to be paid from the escrow account, add a prorated portion of this to your monthly mortgage payment, and pay the bills when due. This means that you don’t have to worry about making large lump sum payments for property expenses once or twice a year—your lender handles this for you.

The lender remits the tax and insurance payments in whatever interval the recipient specifies. For homeowner’s insurance, this is probably going to be once a year. For property taxes, payments could be between one and four times a year, depending on where you live. Escrow transactions are shown on your monthly mortgage statement.

Additionally, your lender will send an annual escrow account statement showing the transaction history and any changes for the coming year. They won’t necessarily send the reconciliation on December 31—it could be sent on the mortgage anniversary or some other date. The reconciliation will likely also tell you how much of a cushion the lender will maintain in excess of the projected disbursements. The cushion is subject to a statutory max of one-sixth of the estimated total annual disbursements from the escrow account. 

As long as you keep your loan with the same lender, you’re going to see the payment go up or down once a year. Escrow amounts will typically change every year to reflect changes in property taxes and insurance. They’re not typically interest-bearing, though, in about a dozen states, including California, lenders are required to pay interest on escrow accounts. If you pay off your loan or refinance, there will likely be a balance left in escrow, which they’ll refund to you.

For many people, an escrow account is a good choice. It’s easy to use, it simplifies your saving process, and it’s relatively worry-free. Below are some insights into the advantages and disadvantages of an escrow account, as noted by Redfin agent Ali Donoghue.

The advantages of an escrow account

  • It’s a built-in savings mechanism. Property taxes are usually due only once or twice a year. This means that after months of making no payment, you’ll be expected to pay several thousand dollars to your local government. If you haven’t been diligently saving for this, it’s easy to be caught without the necessary funds. An escrow account equalizes your payments into regular, required monthly chunks.
  • It means less worry for you. The bank takes on the responsibility of making sure your taxes and insurance are paid in time and in full. If there are any mistakes made, your lender is legally required to pay the associated penalties and rectify the situation.
  • It’s easier to get a mortgage. Many lenders won’t offer a mortgage unless you agree to an escrow. It’s how they protect their investment. So, if you want the most options and best rates, you have to be willing to accept an escrow account.

That said, for certain people, an escrow account is burdensome because it ties up their money. And, even if an escrow account is right for you, you should know about some of the cons.

The disadvantages of an escrow account

  • You have to pay upfront. With interest rates as low as they are, this doesn’t seem like a big deal. But imagine if you could get a 5 percent return in a money market account (it’s hard to imagine right now, but it’s happened before). That’s a return that you would forgo by forking over your monthly payments to the lender. In other words, you could be investing your monthly escrow payment until the actual tax payment is due – which is what your lender is doing. (Note: Some states require that your lender pay interest to you for the money kept in your escrow account. Check with your lender to see if this is the case in your state.)
  • It’s a perpetual cushion that you can’t access. The Real Estate Settlement Procedures Act (RESPA) allows lenders to keep up to two months’ cushion in your account, in case property tax or insurance rates go up. This means that some of your money will be sitting in the escrow account indefinitely until you either sell the property or pay off your loan. Of course, should your property tax bill jump significantly, the cushion can reduce or totally cover the pain of an unexpected extra payment – that’s the benefit.
  • It results in less nimble money management. Here’s a scenario: Yousuccessfully contest your property assessment and your tax bill goes down. You’ll get some money back, right? Well, yes and no. By law, your lender needs to assess your monthly payments at least once a year, so eventually you’ll get the money back in the form of reduced monthly payments or a rebate check. But it may take quite a long time to happen. Or, on the flip side, if your tax bill increases 30 percent, your monthly payments will jump significantly and you may need to make an unexpected lump payment. So don’t let the ease of an escrow account lull you into a false sense of security – always have some extra money saved for unexpected home-related repairs and expenses.

What if you don’t have an escrow account?

If your loan doesn’t include an escrow feature, and you miss a payment on your property taxes or homeowner’s insurance, your lender likely has the right to open an escrow account to take over making the payments.

In addition, if you’ve missed a tax or insurance payment without an escrow account in place, your lender may turn to lender-placed insurance, also known as force-placed insurance. The lender can purchase an insurance policy on the home themselves, to protect their financial interests.

What is force-placed insurance? 

You may encounter force-placed insurance even when you have an escrow account, such as if you fail to purchase or renew a required homeowner’s insurance policy. This can also occur if your regular policy lapses or is canceled, such as if an insurer decides to no longer offer policies in a particular region. And it can also come into play if the bank decides that you need a specialized policy like flood, windstorm, or earthquake insurance. 

Force-placed policies will cost more than what you could buy on the open market. They also have much less coverage and often don’t include liability insurance or coverage for personal items—only the structure itself.  

If the lender decides to purchase a force-placed insurance policy for you, they’ll add the cost to your monthly mortgage payment. If you want to cancel it, you’ll have to show your lender that you’ve purchased a suitable policy, and hope that they cancel the force-placed policy.

Of course, in any of these cases, the lender is likely required to notify you that you aren’t maintaining the required insurance and give you a chance to correct the situation before turning to a force-placed policy. So, it pays to keep an eye out for any correspondence from your lender and insurer.

How does private mortgage insurance work with escrow?

In addition, if your loan-to-value ratio (LTV) is above 80%, typically because you’re making a down payment of less than 20%, the lender may require that you purchase private mortgage insurance (PMI) through them. This protects the lender, not you. The cost of PMI will be included in your monthly escrow payment.

Other things to consider about escrow accounts

If your loan doesn’t include an escrow account, you may be able to request one. There usually isn’t a charge for opening an escrow account, but you may have to put down a substantial deposit. If payments are due only once a year, and you open an escrow account just before your taxes are due, you’ll essentially be pre-paying for a year’s worth of expenses.

If the home you’re buying is located in a community served by a homeowner’s or condo association (HOAs), your lender may be willing to pay your HOA dues through your Escrow account, though this is not very common. 

While escrow may seem complex, and there are indeed many moving parts, it’s important to have a high-level understanding of how it works. That way, you’ll be able to confidently follow along with the escrow process as you buy your home, make mortgage payments, and eventually refinance or pay off your loan.

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