Almost everyone has heard the term escrow being used in regard to real estate, particularly in phrases like “escrow account” and “in escrow.” But is escrow a person? A process? A legal state? Today, we’ll clear up what escrow actually is, and explore the role it plays in the purchase of a new home.
What is escrow, exactly?
Escrow is actually a broad term related to financial transactions between multiple parties, typically involving a buyer, a seller, and a neutral third party not directly involved in the sale. In an escrow arrangement, the escrow party will hold money, documents or deeds related to the sale for the term in which the obligations outlined in the contract between buyer and seller are completed. Once the deal or sale is finalized (in the case of a home, at the closing) the funds in escrow are disbursed to their rightful owners.
Why is escrow used?
Escrow is a convenient way to allow both buyer and seller to remain confident in the business transaction at hand, without either having to collect or forfeit money before the successful conclusion of business. For instance, some buyers are required to put up “earnest money” or a “good faith deposit” when bidding on a property, in order to show that they are “earnest” about wanting to buy. However, some buyers may think twice about forfeiting such money to a stranger, particularly if any unexpected complications should arise (such as a dire problems revealed by an inspection of a used home) that threaten the sale of the home. Placing this earnest money with a third party allows the seller to see that the buyer is capable of funding the purchase and is in earnest about their bid, while also allaying any fears the buyer may have about losing money to an unscrupulous seller.
My mortgage lender mentioned something about escrow to pay taxes and insurance. What does this mean?
Some lenders keep an escrow account in which funds are collected to pay the taxes and insurance on a mortgaged home. Because failure to pay taxes and insurance coverage severely affect the value of a home as collateral against a mortgage, lenders tend to ensure these important bills are paid by paying them for the borrower. The total taxes and insurance payments for the year are calculated, then divided by twelve to yield a dollar amount that is added to the monthly principle and interest payment. This extra money is funneled into an escrow account from which the taxes and insurance on the home is paid. Some lenders require an escrow account for only a few years, while others require escrow accounts for the life of the loan. As you can see, this particular usage of escrow differs from the usage of escrow accounts outlined above.
So how does escrow come into play at the closing?
In some parts of the country, a pending home sale is referred to as being “in escrow.” This simply means that a binding contract between the buyer and the seller has been initiated, and the sale will proceed as planned once the contingencies of the contract have been satisfied. Fees such as earnest money, deposits, and even seller rebates have thus been deposited into an escrow account until the home sale is finalized. At the closing, checks from this account are presented to the various parties, and, as the funds are fully disbursed, the escrow is then considered closed.