Escrow: What Is It And How Does It Work?

If you’re buying a home, you’ll probably hear the word “escrow” used in a few different contexts. Essentially, escrow is a financial arrangement where a neutral third party holds funds or assets on behalf of two parties involved in a transaction until specific conditions are met. This is especially relevant during the home buying process.

Whether you’re a home buyer, seller or a current homeowner, understanding how escrow works and its benefits can help you navigate the complexities of real estate transactions with more confidence and ease.

How Does Escrow Work?

An escrow agreement is used in real estate transactions to protect both home buyers and sellers during the home buying process. Throughout the term of the mortgage, an escrow account will hold funds for taxes and homeowners insurance.

What Is An Escrow Account?

In real estate, escrow is typically used for two reasons:

• To protect the buyer’s good faith deposit, so the money goes to the right party according to the conditions of the sale.
• To hold a homeowner’s funds for property taxes and homeowners insurance.

Because of the different purposes served, there are two types of escrow accounts. One is used during the home buying process, while the other is used throughout the life of your loan.

 

Escrow Accounts For Home Buying

When you’re buying a home, your purchase agreement will usually include a good faith deposit, also known as earnest money. This deposit shows the seller that you’re serious about purchasing the home. If the contract falls through due to the fault of the buyer, the seller usually gets to keep the money. If the home purchase is successful, the deposit will be applied to the buyer’s down payment.

To protect both the buyer and the seller, an escrow account is set up to hold the deposit. The good faith deposit sits in the escrow account until the transaction closes.

Sometimes, funds are held in another type of escrow account past the completion of the sale of the home. This is called an escrow holdback. There are many reasons an escrow holdback may be needed. For example, perhaps you agreed that the seller can stay in the home an extra month, or there are outstanding bills on the home that the seller is responsible for (like a water bill).

If you’re building a new home, money may remain in escrow until you’ve signed off on all the work. Once the conditions are met, the money will be released to the right party.

Escrow Accounts For Taxes And Insurance

After you purchase a home, your mortgage lender will establish an escrow account to pay for your taxes and homeowners insurance. Each month, your mortgage servicer takes a portion of your monthly mortgage payment and holds it in the escrow account until your tax and insurance payments are due.

The amount required for escrow is a moving target because your tax bill and insurance premiums can change from year to year. Your servicer will determine your escrow payments for the next year based on what bills they paid the previous year. To ensure there’s enough cash in escrow, most lenders require a minimum of 2 months’ worth of extra payments to be held in your account.

Your lender or servicer will analyze your escrow account annually to make sure they’re not collecting too much or too little. If their analysis of your escrow account determines that they’ve collected too much money for taxes and insurance, they’ll give you what’s called an escrow refund.

If their analysis shows they’ve collected too little, you’ll need to cover the difference. You may be given options to make a one-time payment or increase the amount of your monthly mortgage payment to make up for a shortage in your escrow account.

Who Manages An Escrow Account?

Escrow accounts may be handled by a variety of third parties, including an escrow company, escrow agent or mortgage servicer. Where you are in the process will determine who manages the account.

Escrow Companies And Escrow Agents

When you’re buying a home, escrow may be managed by a mortgage servicing company or agent. The escrow agent or company is sometimes the same as the title company.

The escrow company not only manages the buyer’s deposit, but they may also be responsible for holding the deed and other documents related to the sale of the home.

Because the escrow company is working for both the buyer and the seller in the real estate transaction, the fee for their services is usually split evenly between the two parties.

Mortgage Servicers

Your mortgage servicer manages your mortgage, from closing until you pay off your loan. Mortgage servicers are responsible for collecting your mortgage payment, maintaining the records of payments and managing your escrow account.

Your mortgage servicing company is sometimes your originating lender – but not always. Sometimes, lenders sell the servicing rights to your loan. It’s a good idea to know ahead of time whether your lender typically services their own loans. Not all mortgage servicers provide the same level of service.

With your mortgage servicer taking care of your escrow account, you don’t have to worry about your tax or insurance bills – your servicer will make sure they know who to pay, and when.

The only exception is if you change insurance providers or policies. You will need to provide the new policy information to your servicer.