Real estate transactions involve moving or the exchange of money at various stages. As you begin your homebuying journey, you will hear the word escrow at some point, most likely from your real estate agent.
It can be overwhelming to understand all the parts of the transaction process, but escrow is really there to protect both the buyer and the seller. It’s also risky if not done carefully, as cybercriminals are more actively seeking ways to intercept the escrow funds than ever before.
Take time to understand the process and ask your title agent questions before sending money through a wire transfer. We’re diving into what escrow is, how it works, its calculation, and why it’s essential for real estate transactions.
What is Escrow?
An escrow is a legal agreement between two parties to designate a trusted, neutral third party to receive and disburse funds or property after they meet the conditions of their contract.
How Does Escrow Work?
Escrow can refer to a situation where a third party holds onto a real estate transaction’s earnest money deposit when a property purchase is in a contract. It can also refer to the third party themselves – often an escrow agent. The escrow agent’s job is to protect the transacting parties until closing.
Therefore, if a party fails to meet any of the agreed conditions in the sales contract, they will not receive the cash or property until they do. Consider escrow as a good-faith deposit indicating buyers are serious about their offer since backing out at the last minute and breaking the contract means the escrow money will compensate sellers for lost time.
The person who acts as the escrow agent is usually from the closing company, a title company agent, or an attorney. The transacting parties will send documentation to the escrow agent to inform them of the process and the state of the conditions. For example, if the sales contract includes a home inspection contingency, the seller cannot move forward with the deal until an inspection officer gives them the green light.
Once the conditions are met, the parties schedule a closing day to finalize the deal. Finally, the escrow agent releases the cash held in escrow, and buyers receive the property title, ending the process.
When is Escrow Used?
Many people likely encounter escrow during a real estate transaction, but it’s also used in online sales or the stock market to manage stock distributions.
The most widespread use of escrow services is in real estate, though. In fact, an escrow agent’s job is among the top five essential roles in the title industry. The agent acts like a middle person to hold and disburse funds as per the real estate contract the buyer and seller of real property created.
Online sales of rare and expensive items, like art or jewelry, often use escrow services to ensure the arrival of the promised item. The escrow agent will only release the funds to the seller after the delivery and authentication of the product.
Companies often use stock held in escrow as an incentive to retain talent and prevent staff turnover. Therefore, they compensate their high-performing executives with stock bonuses. However, the recipients cannot sell the stock until the lapse of an escrow period.
Types of Escrow for Real Estate
There are two reasons for escrow in a real estate transaction:
- Ensure earnest money deposit goes to the appropriate party as per the existing real estate contract terms. It protects buyers if the contract has a clause to get money back if either party reneges out of the deal.
- Ensure future home insurance and property taxes payments come from a homeowner’s funds. It protects lenders and their priority lien (mortgage) on the property. Unpaid property taxes can jeopardize a lender’s right to foreclose and get paid first.
Due to the different purposes that escrow accounts serve, these accounts come in two types:
- An escrow account for the homebuying process
- Another account used throughout the life of the home loan
Will Escrow Be Waived?
An escrow waiver is contingent on the buyer continuing to pay their bills on time and satisfying any required conditions. For example, some conventional lenders can waive escrow after the buyer makes 12 on-time mortgage payments and their loan-to-value is generally 80% or lower.
Can Escrow Close Early?
Yes, but only if everything goes smoothly and the parties satisfy all required conditions.
Who Opens the Escrow Account?
The seller’s real estate agent often opens an escrow account. However, anyone involved can do it, including an attorney or an agent from a closing or title company.
Why Does Escrow Go Up?
Escrow goes up due to increased insurance costs or taxes. It can also increase if the mortgage servicer’s analysis reveals that you don’t have enough money to meet tax and insurance payments in your escrow account.
What is Escrow Disbursement?
It’s when your escrow account makes a payment.
What’s the Escrow to Mortgagor Disbursement?
It’s a payment a lender or mortgage servicer makes on behalf of a borrower out of their escrow account to cover homeowners insurance and property taxes.
Escrow Accounts for Homebuyers
The purchase agreement usually includes earnest money (a good faith deposit) during the homebuying process. The deposit shows a buyer is serious about purchasing a home. Often the buyer decides the amount they put up as earnest money, usually between one and three percent of the home purchase price. However, it can be any amount, even as little as $250. However, a large earnest money deposit helps buyers stand out in a competitive market.
If the buyer reneges on the contract and it falls through due to their fault, the seller keeps the earnest money. If the purchase is successful, the escrow agent will apply the earnest money to the buyer’s down payment on the home.
In some instances, the escrow agent holds funds past the completion of the home sale in what’s called an escrow holdback. There are several reasons for an escrow holdback delay, such as a buyer agreeing that the seller can remain in the sold home for an extra month as they prepare to move out, or maybe a final property walkthrough revealed something wrong.
If the property sold is new, an escrow holdback can occur until a new home inspection and the seller signs off on the work and closing costs. The escrow agent releases the money after the seller meets the conditions.
Escrow Accounts for Insurance and Future Taxes
After purchasing a home, your lender establishes an escrow account to help pay your property taxes and homeowner’s insurance. Then, it’s added to the total monthly payments to help new homeowners manage their upcoming payments.
After closing a property, the mortgage servicer holds a portion of the monthly mortgage payments in escrow until the buyer’s insurance and tax payments are due. These increased payments are the con of escrow accounts.
Lender vs. Servicer: How to Calculate Escrow
Since tax bills and insurance premiums can change annually, the amount held in escrow fluctuates. In addition, the bank that loans buyers money is not always the same entity to collect payments (mortgage servicer).
The servicer determines the monthly escrow payments for the year based on previous payments. Most lenders require buyers to hold at least two months’ worth of extra payments to ensure enough cash in escrow.
An escrow refund occurs when a lender’s analysis reveals they have collected a lot of money for taxes and insurance. However, if it shows they have not collected enough money to cover the difference, the buyers can make a one-time payment or increase their monthly mortgage payment amount.
It’s also essential to note that buyers with an escrow shortage may have to pay an increased monthly amount because the mortgage servicer recalculates the payments based on the escrow analysis.
How Long Does the Buyer Pay Escrow?
Escrow mortgage payments can last the loan length, while some lenders may not require buyers to set up escrow. Additionally, lenders have different requirements for ending escrow. For example, many may entertain a written request to remove escrow after the buyer makes 12 on-time mortgage payments and their loan-to-value is generally 80% or lower.
Property Expenses Escrow Doesn’t Cover
Escrow accounts don’t cover all the buyer’s homeownership expenses. For example, your servicer or lender will not collect money to pay HOA fees or utility bills. Other costs escrow does not cover are supplemental tax bills – one-time bills incurred due to new construction or ownership changes.
Is an Escrow Account Required?
There is a potential for buyers to pay their property taxes and homeowner’s insurance out of pocket instead of using escrow accounts. It lowers their monthly mortgage payments. However, not everyone can opt out of having an escrow account with their mortgage servicer. In addition, certain loans require escrow accounts, for example, FHA loans.
Those that allow buyers to opt out of escrow payments have specific requirements as follows:
- VA loans require 10% down plus a strong credit profile to end escrow payments
- Conventional loans require 20% down payments
Additionally, it’s possible to use escrow accounts for some expenses, such as paying property taxes alone but not homeowner’s insurance.
Be Informed When Using Escrow
Escrow is important in building trust between both parties in a real estate transaction. It’s a secure way to show that a buyer is interested in a property and plans to proceed with the purchase.
However, wire transfers are also susceptible to wire fraud and similar schemes, as thousands of dollars are handled daily. Make sure to communicate effectively with your title company, verify information in person or over the phone, and understand how the money is used before sending it off to your title company.
Looking for more homebuyer resources to share with your customers? Check out some of our other popular blogs that cover the basics of real estate:
- Every Step of a Real Estate Transaction Explained
- What Does a Title Insurance Company Do?
- How to Calculate the Wealth In Your Home
- What Are Different Types of Liens?