6 min. read
When buying a home, you’ll undoubtedly encounter the term “escrow” a few times. And, if you’re a first-time buyer, it might be confusing as there are different types of escrow required when buying the home. So, below, we’ll take a look at the main types of escrow you’ll have to deal with when purchasing a property.
What is an Escrow?
Escrow is when a third party holds onto a particular asset until certain conditions are met. This service protects buyers and sellers, making sure that both sides of the agreement fulfill their obligations.
As a buyer, you’ll be required to pay a deposit that will go into an escrow account. An escrow agent will oversee this account, releasing the funds to go toward paying for the home if everything goes according to plan.
However, if the seller breaks the terms of the contract, the funds can be returned to the buyer. Alternatively, if a buyer decides not to proceed with the purchase and the terms of the contract allow this, their deposit can be returned to them.
Alternatively, if a buyer decides to back out of the deal in a way that isn’t allowed in the contract, the escrow funds can then go to the seller to compensate them for their time and trouble. Therefore, holding the buyer’s funds in escrow encourages them to continue with the deal because their money is at risk.
Escrow Before You Buy
When a seller agrees to the offer made by a buyer, a purchase agreement is signed. Most likely, the buyer will then be expected to make an earnest money deposit fairly quickly, which will go into an escrow account until closing. Often, a title company or real estate agent might act as the escrow agent responsible for managing the funds as agreed upon in the contract. This entails disbursing the funds at the proper time to the proper person, as detailed in the terms of the purchase agreement.
The earnest money could be 1% or 2% of the purchase price and demonstrates that the buyer is serious and committed to buying the property. It can also be used toward the down payment or to cover other costs at closing.
Meanwhile, the purchase contract is likely to contain contingencies that allow buyers and sellers to exit the agreement under certain conditions. For example, if serious faults with the property are found during the home inspection, an inspection contingency could allow a buyer to walk away with their earnest money returned. Conversely, if the buyer fails their mortgage application, a contingency can allow the seller to find a new, qualified buyer.
However, if a buyer decides that they want to break the contract for reasons not covered by contingencies, they’re likely to lose their deposit. But, if a contingency protects the buyer, they should get most of their deposit returned to them.
In any case, having escrow is an integral part of closing on a property in most real estate transactions.
Escrow & Lenders
Another important type of escrow involves your lender, although mortgage escrow doesn’t work in the same way as the escrow involving the seller — it really only exists to protect the mortgage lender.
For instance, when a mortgage lender loans money to a borrower, the home is collateral. Should the borrower default on the loan, the home can be foreclosed, thereby allowing the lender to get their money back. But, if the homeowner fails to pay their property taxes, it can potentially affect the lender. Another potential issue is a fire or another type of damage to the property — which, if uninsured, can affect the investment the lender has made. For these reasons, mortgage lenders require an escrow to pay home insurance and property taxes.
Normally, property taxes and insurance premiums are required to be paid annually, but mortgage escrow allows the borrower to pay these fees gradually each month. The lender sets the amount required based on the previous year’s property taxes for the home, which also allows for easier budgeting for the homeowner. So, instead of having to find a potentially substantial amount of money once a year to cover these taxes and premiums, the borrower doesn’t have to worry about saving to cover these bills.
Finally, there may also be an extra expense on top of the additional monthly payments if taxes and insurance premiums increase. But, this should be less of a concern because most of the fees will have already been covered as part of mortgage payments. A borrower might even get a refund should they pay too much into escrow or if the loan is paid off.
What Happens with Escrow at Closing?
Typically, if everything has gone according to plan, escrow funds will be put toward a down payment and other expenses at closing. However, in some situations, all or some of the earnest money could be returned to the buyer. This can occur if the buyer doesn’t need to make a down payment, such as through a VA or USDA loan. Or, sometimes, the seller might agree to cover some of the closing costs, in which case the buyer would get some of their deposit back.
If a buyer is required to pay mortgage escrow, they’ll need to make the initial payments at closing, which could be at least two months’ worth of insurance and taxes to create a reserve.
Note that funds placed in escrow have to be kept separate from other money. In fact, by law, escrow money must be placed in a separate account by the agent. A separate account is also important with mortgage escrow because it makes it easier to separate mortgage and interest payments from the money you’re paying toward taxes and insurance. And, while there isn’t a legal requirement to place earnest money in an escrow account, it is a generally accepted norm.
As far as the escrow agent, this is usually up to the buyer. The buyer’s real estate agent will likely be able to recommend a reputable agent, and the deposit should never be given directly to the seller. While mortgage escrow isn’t always required by lenders, the terms of the loan could be better when it is required. As an example, if you have a 20% down payment, you might be able to avoid mortgage escrow, but the lender could require other fees to be paid.
As you can see, escrow funds can serve multiple purposes in a real estate transaction. Whether you’re buying or selling a house, it’s essential to have at least a basic understanding of how escrow works.