What Is Escrow In Real Estate?
An escrow is a legal agreement or pledge between two parties that allows a third party to hold assets or money on their behalf until the terms and conditions of a sale or change of ownership can be fulfilled. Investopedia describes how, in real estate, it's a safeguard for both buyer and seller, a way to protect both sides' interests until the real estate deal can be concluded.
The concept has been around for quite some time, as the word "escrow" comes from a 16th-century Middle English/French word "escroe," meaning a scrap of paper. Important agreements between two parties would have been written down even then, although paper was somewhat scarce.
While the term is most often used in reference to a real estate deal, the concept itself — a trusted third party holding money until an issue is resolved -– is used for the stock market and increasingly in online sales for big-ticket items such as jewelry or art. In real estate, escrow protects both buyer and seller, although in different ways.
Holding earnest money in escrow
Rocket Mortgage explains how most homebuyers will need an escrow account to hold their earnest money. Consider a house for sale on the market today; while there may be several people interested in buying it, the seller agrees to sell to a particular person and agrees to take the house off the market until the purchase can be completed. In exchange, the buyer agrees to reserve or hold the house by giving the seller a down payment in the form of earnest money. Depending on the terms of the agreement and the lender's expectations, the earnest money can be from 1% to 10% of the home's purchase price.
The earnest money does not go from the buyer to the seller directly but instead is held by a third party -– sometimes the mortgage company, sometimes a title company or bank. The money is being held "in escrow." This is because most real estate deals are laced with contingencies or stipulations regarding the deal. For example, a house sale may depend on a favorable whole-home inspection -– if there are too many unseen mechanical or building problems, the house may not be as valuable as the agreed-upon sale price. A contingency might be for the seller to consent to make some repairs before the sale can be completed. While those repairs are made, the buyer's earnest money or down payment is held in escrow.
Contingencies and earnest money
Once the contingencies of a house sale are satisfied, and both buyer and seller agree they are satisfied, the sale moves forward, and the earnest money held by the designated third party goes towards the down payment of the house. Occasionally, the seller is not willing or able to make the needed repairs or comply with all the contingencies in the signed contract. In this case, the seller is out of compliance, that is, not meeting their obligations, and if the buyer no longer wants the house, the earnest money is returned.
Sometimes, however, the buyer is at fault for a failed sale. In this case, the seller may legally keep the earnest money in the escrow account, basically for their time and trouble and the fact the house was off the market for a period of time. Realtor.com describes how buyers can lose their earnest money: First, if the buyer skips over their protections and waives contingencies. Second, if the buyer can't fulfill all their obligations within the time frame of the contract. Third, if the buyer gets cold feet and suddenly decides the house isn't for them. Because of the signed contract, the earnest money held in escrow would be kept by the seller.
The homeowner's escrow account
Once a buyer becomes a homeowner, chances are there's a mortgage involved, although some buyers pay for their home in cash. (Back to that thought in a moment.) If the homeowner is working with a lender, that institution will help set up an escrow account to receive mortgage payments, but also to collect insurance and taxes monthly. While the homeowner is paying the principal back to their lender, whether it's a mortgage company or bank, they are also paying annual taxes and insurance costs a little at a time. The lender holds these payments in escrow, then sends the money to the city, state, and insurance company as the payments become due.
Bankrate points out the advantages of having an escrow account married to your mortgage payment. The mortgage company will pay your taxes on time, automatically. The mortgage company does this to be sure no lien or penalty is placed on your house. Another advantage is a payment that tends not to change from month to month. While there may be increases over time – and you would be informed of that – your basic payment is steady and predictable, which is good news for your budget.
Cash buyers benefit from escrow too
Quicken Loans says that buyers who pay in cash, as well as people who have paid off their mortgage loan, can still benefit from an escrow account with the financial institution of their choice. When there is no mortgage payment (no repayment of money loaned), many people still find it easier to pay taxes and insurance throughout the year through an escrow account. Meaning they choose to pay a financial institution monthly as if there were a mortgage. The alternative is to pay the taxes and insurance on their own. However, many people find it easier to make these required payments throughout the year, as opposed to scraping up all the money needed when the tax bill is due quarterly or annually.
And just in case the buyer is nervous about their money disappearing altogether, Brick Underground points to the fact that escrow fraud is quite rare. For attorneys, the breach of confidence is a good way to lose a license. For banks and mortgage companies, not distributing the comparatively small amount of money held in escrow for a single sale simply isn't worth the loss of public trust in their financial dealings.
Escrow disadvantages
MasterClass mentions a downside to having an escrow account. The first one is that adding taxes and insurance to your mortgage payment naturally makes the payment higher. Another disadvantage is that an escrow account is an estimate not only of what the house is worth but what the taxes and insurance cost as well. Most often, homeowners see an increase in their taxes and coverage, especially in the first few years. If the escrow account is short, the homeowner must pay the difference out of pocket. If the escrow account is over, the lender may offer to reimburse the homeowner or may apply the overage to the next payments.
Finally, a third disadvantage is closely related to the second. If you're the type of financial person who wants to pay the exact amount of taxes and insurance annually, with no estimating, skip the escrow account, pay the mortgage monthly, then pay the other costs as they become due. The trick to this is either to have a lot of cash flowing into your budget so you can readily pay taxes and insurance all at once or save up a bit every month to pay off the annual expense.
Note too that some kinds of loans, such as FHA loans, require an escrow account. For specifics on your mortgage, be sure to talk with your lender about the kind of payment schedule that works best for you and your family.