Escrow accounts are prevalent in real estate transactions. For example, the lender will usually require you to place money in an escrow account when you take out a mortgage. While this is completely normal, many first-time buyers are confused by this concept, wondering what “escrow” means.
When it comes to real estate or other financial transactions, escrow is used to protect both the buyer and the seller, with a third party holding the funds on behalf of both other parties. The third party can be an escrow company, law firm, or title company, and they hold the money in an escrow account, protecting your funds and the parties involved by making sure the terms of the agreement are handled fairly.
This article explores escrow accounts and how they work, so keep reading to learn more.
What Is Escrow in General?
With escrow, a third party holds money or other assets like stocks and securities for two other parties that are in the process of completing a monetary transaction. Still, the third party doesn’t own the escrow account. Instead, he acts as a keeper.
There are different types of escrow accounts to suit various financial transactions, whether related to real estate or not.
What Is an Escrow Account?
An escrow account is an account that ensures trust between two parties and protects them in different transactions. Since a third party holds an escrow account, it doesn’t belong to any of the parties.
An escrow holder transfers the money or other assets to the seller if everything goes according to plan, every point of the contract is respected, and the sale completes. If the buyer cancels the sale under the circumstances not allowed under the contract, the escrow money still goes to the seller. However, if the seller backs out under the same conditions, the money returns to the buyer.
Who Manages Escrow Accounts?
Depending on where you are in the process, different parties will manage the escrow account. For example, during the buying process, an escrow agent, often employed by the title company, may manage the escrow account, making it easy for them to maintain custody of the deed and other documents, for instance. However, third-party escrow companies can perform the same functions.
After closing on your new home, your mortgage provider, usually your original lender, will manage your tax and insurance escrow account.
How Much Does Escrow Cost?
The escrow fees will vary depending on the location of the house and the escrow company. But typically, the fee is 1% to 2% of the purchase price. Since escrow protects both the seller and the buyer, they usually divide the cost at closing.
Different Types of Escrow Accounts
While escrow accounts are prevalent in real estate, they can also be used in other financial transactions. Here are some of the most common types of escrow accounts.
Mortgage Escrow Account
With a mortgage escrow account, you make monthly payments for your homeowner’s insurance and property taxes. It begins at loan closing and lasts until your loan ends.
The money is held by the mortgage company and added to your monthly mortgage payment, and they pay your property taxes and homeowners insurance in due time instead of you. When you finance more than 80% of a property’s value, escrow accounts are usually required.
Home Purchasing Escrow Accounts
A home-buying agreement typically requires a good-faith deposit, and if you cancel the purchase, the seller often keeps the deposit. On the other hand, in case the seller backs out, the deposit returns to you. Once the buy is complete, the deposit goes toward the down payment.
Typically, this type of escrow account closes at the same time as the real estate, but sometimes, the money stays in an escrow holdback. This is performed when some conditions regarding the sale still linger, such as when the seller remains in the home for a specific period. In this case, the money will be allocated once the seller moves out of the home.
Business-Related Escrow Accounts
As we mentioned, escrow accounts can be used for various purposes. They can be valuable in any event where two parties want protection until the terms and conditions are met.
For example, landlords sometimes fail to make repairs on time, and a renter’s escrow account enables you to place your rent with a third party, which will be given to your landlord once he makes the needed improvements.
An escrow account can be useful when it comes to online shopping too. That’s especially true in the case of high-value products. In this case, the buyer will put the money into an escrow account. The money will be held in the account until the product is received and then released to the seller.
Stocks are also commonly held in escrow for different reasons, including acquisition, bankruptcy, reorganization, or during the merger. For example, a company may hold stocks in escrow that has been awarded to an employee as an incentive to keep the employee in the company.
Benefits of Escrow Accounts
An escrow account protects all parties involved in a financial transaction. Here are some of the benefits it offers:
- Buyers: Let’s say you want to purchase a house, but after the inspection, you discover there’s mildew in the walls. If the seller doesn’t wish to pay for a reduction, the sale fails. And if, on top of that, they refuse to give you back your deposit, you could end up losing your money. However, with escrow, you’re protected from such situations as it guarantees you’ll get your deposit back.
- Sellers: Buyers may avoid making a good faith deposit without escrow accounts. But with escrow accounts, you can have peace of mind the transaction will be fair.
- Lenders: Lenders need to know their insurance and taxes are paid on time because, if not, local tax authorities may put a lien on the property. If there’s significant damage to the home and you don’t have insurance, you may need to move out of the property. That’s when the bank will have to foreclose, and lenders will be responsible for those repairs. Escrow accounts protect lenders from such situations.
- Homeowners: With escrow, homeowners don’t need to save money on the side to make separate payments for insurance and taxes or track the billing. The lender manages everything on behalf of homeowners, and homeowners pay it through their monthly bills.
Protect Yourself with Escrow
After reading this article, you have a good idea about what escrow accounts are and how they work. Escrow is used to protect the parties involved in a financial transaction, whether real-estate related or not.
A third party holds the funds in an escrow account until the contractual obligations are met, protecting buyers from losing their money and ensuring sellers get paid for their properties. They also protect homeowners and lenders. Besides real estate, they can be used in other financial transactions. For example, when buying an expensive piece of art.
Why risk losing your money or ending up in a home that desperately needs repairs when everything can go smoothly and end up fairly with escrow?