What Is Escrow?
In short, escrow is an arrangement between two parties in which funds or property are managed by a neutral third party that keeps those funds or property safe and manages how and when they are disbursed. Escrow can be used for other transactions besides the sale of real estate. However, in real estate, escrow is most commonly used to manage related transactions, including earnest money deposits before a sale closes, the distribution of funds at the sale’s closing, and the funds and payments needed for property taxes and insurance after the sale.
Reasons You Need To Use Escrow Accounts
At different stages of a home purchase, the use of escrow accounts (sometimes called “impound accounts”) has benefits for the homebuyer and if the home is financed, the mortgage lender.
Protection for Buyers
The first way escrow is commonly used in real estate is to hold earnest money. This is a deposit made by a buyer after signing a purchase agreement, and it demonstrates a serious intention to buy.
Protection for Lenders
Another way escrow accounts are commonly used in real estate is by mortgage lenders. After a home sale is completed, rather than rely on the borrower to pay property taxes, mortgage insurance, and home insurance premiums on time, many lenders add the estimated costs into monthly mortgage payments. The mortgage servicer then deposits these “extra” funds into an escrow account and takes responsibility for paying the bills on time. So how exactly does this process help protect the lender? Let’s look at two scenarios. Scenario 1: Miguel, the buyer, procures a mortgage to purchase a home. His lender does not require an escrow account, so he simply pays his monthly mortgage payment (principal plus interest). But money is tight, so Miguel doesn’t save for taxes and insurance premiums, and cannot pay them. Money gets tighter, Miguel no longer makes mortgage payments, and it’s time to foreclose. Since the house was collateral, the lender can sell it to make up the unpaid portion of the loan. Now, however, there’s a lien on the property for back taxes. In order to sell, the lender has to resolve the lien, costing extra time and money. Scenario 2: Another buyer, Haleigh—also responsible for paying her own taxes and insurance without an escrow account—keeps up mortgage payments and taxes but neglects to pay home insurance premiums. Coverage lapses. So when her home is destroyed in a fire, not only does Haleigh lose everything without insurance to pay for rebuilding, but the now-vacant property is no longer sufficient collateral to help the lender recover the balance of her loan.
How Escrow Works in Real Estate
Now that we know why escrow is important in real estate, let’s look at some of the specifics you may encounter in the home sale process.
Using Escrow for Earnest Money
If you’re buying a home and making an earnest money deposit, ask your real estate agent about their typical process for this. Some real estate agents and brokers may manage the escrow process for you; you may need to set up escrow for yourself; or the title company you plan to use for closing may handle the deposit. Both buyers and sellers should make sure the purchase agreement specifies the conditions if the earnest money is returned or forfeited. For example, if the sale falls through due to issues found on an inspection, will the buyer receive the deposit back? What about if financing falls through? When it’s time for the sale to close, the earnest money will be released to count toward the total purchase price. Until that point, using escrow protects the buyer’s deposit.
Using Escrow for Ongoing Taxes and Insurance Premiums
Many lenders require escrow, and in some cases, escrow may be legally mandated. If your lender does require escrow, the mortgage servicer will manage the escrow account and pay the taxes and insurance fees when they are due.
Understanding Escrow Statements
Lenders are required to give borrowers their closing disclosure documents at least three days before a sale closes so buyers have time to review details of their financing and ask any questions. When escrow is included in the loan, these documents will include an initial escrow disclosure statement. You should see the following projections on your initial statement:
Total monthly paymentBreakdown of monthly amounts for principal, interest, and escrow fundsAnticipated monthly escrow paymentsEstimated disbursements (payments from escrow for taxes and insurance)Anticipated running balance
Moving forward, you should also receive an annual escrow statement from the lender detailing the previous year’s account activity and current balance, as well as projections for the next year. This statement should also specify what will happen to any surplus or how potential shortages will be resolved. When there is a surplus in the account at the end of the year, you may receive a refund from your servicer for that amount.
If Your Lender Doesn’t Require an Escrow Account
If your lender doesn’t require you to have an escrow account, it’s a good idea to request one. That way, you’re not surprised or unprepared when the time comes to pay taxes and insurance premiums, which can be hefty. If you need to open your own account, contact the bank of your choice to let them know. They’ll collect pertinent details and help you set it up.
The Cost of Escrow Fees
When closing day arrives, a portion of the closing costs will go toward escrow fees. Depending on the sale, these may be paid by the buyer, the seller, or both. These fees go to a third party called an escrow agent, whom the buyer and seller have agreed to use to facilitate the paperwork, closing process, and disbursement of funds. This takes place beginning with the signing of the purchase agreement all the way until the keys are handed to the new homeowner. This escrow agent might be an attorney, a title company, or an escrow company. Cost will vary depending on location, the escrow agent, and the terms of the sale. However, common estimates of escrow fees are 1%-2% of the purchase price of the home. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
