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What is an Escrow Account and How It Works in Real Estate

February 15 2018
by Ben Mizes

If you’re looking to buy or sell a home, at some point in the process, you will almost certainly come across the word “escrow.” The term escrow is widely used across financial transactions in general, although most people will not come across it frequently until they enter the world of residential real estate. Even there, escrow tends to be used two separate ways, making it even more confusing. While escrow accounts can seem like a complicated lending subject, it is essential for buyers and sellers alike to learn what an escrow account is, why an escrow account exists, and how it benefits both the lender and the parties involved.

What is An Escrow Account?

An escrow account is a safe third party account used for a specific, stated purpose. At its core, an escrow account is essentially a holding cell for safekeeping important documents.

Why do people use escrow accounts?

In a large transaction with multiple moving parts, all parties want assurance that no funds or property will exchange hands until every instruction in the transaction has been followed. This goes for buyers, sellers, lenders, and borrowers. The escrow holder’s main obligation during the transaction process is to safeguard the funds and documents until the provisions of the escrow have been complied with. With this protection in place, each party in the transaction removes the risk that one of the important documents isn’t there.

Types of escrow accounts

There are two types of escrow accounts in real estate – mortgage escrows and real estate escrows.

  • Mortgage Escrow

A mortgage escrow account is an account the mortgage lender establishes to pay for certain property-related expenses on behalf of their clients. If a buyer’s loan has an escrow account, they will pay monthly installments for taxes, insurance, and the monthly mortgage payment. Both tax and insurance bills are paid annually, but most lenders require you to pay 1/12th of the annual bill each month.

  • Real Estate Escrow

In the home-buying process, a real estate escrow account keeps sensitive paperwork safe and secure until the home officially transacts from the seller to the buyer. Some of the sensitive items held in the escrow account include the earnest money check, the funds, instructions, and paperwork necessary for a pending real estate sale. Contained in these documents are funds for the downpayment, sales contracts, inspection riders, and the deed to the home.

How Does a Real Estate Escrow Work?

An escrow operates with four main principles: the buyer, seller, lender, and borrower. Typically, the buyer’s and seller’s real estate agents and the bank will cause escrow instructions to be created, signed, and delivered to the escrow officer. Following these guidelines, the escrow officer, usually a title company employee or lawyer, will process the escrow. While the escrow officer monitors the escrow account, the buyer and seller work out the details of the transaction. When all conditions required in the escrow are met, the escrow will “close” and the transaction officially takes place.

The Deal Falls Through – What Happens to Earnest Money?

A real estate sale might not close for a number of different reasons. In fact, Trulia released a study that shows 3.9% of transactions failed in 2016. Some of the more common causes include a buyer not qualifying for a mortgage or unknown issues with the property rising to the surface during the home inspection. When one of these qualifying events happen, the sale “falls out” of escrow. What then happens to the escrow funds varies based on several factors, such as who was “at fault” for the failure.

If a buyer withdraws from a sale without a good reason, the buyer’s earnest money held in the escrow account may go to the seller. On the other hand, if the seller cancels the sale, the buyer’s funds will be returned. The coordination of how escrow funds are handled in each of the various situations are contained in the purchase agreement, a document which diligent buyers and sellers should read very carefully.

How Does a Mortgage Escrow Work?

A mortgage escrow exists primarily between the lender and the home buyer. When the home buyer secures a mortgage, the lender will usually require that the buyer open an escrow account. An escrow account can be obtained through the lender, or by a third party called an escrow agent. When the account is opened, the homebuyer is usually required to make a deposit in advance as a financial cushion. This ensures there will always be enough in the escrow account to cover the amount of the estimated tax and insurance payments.

The lender will subsequently add the estimated taxes and insurance premiums to the principal and interest payment for the home. Since the property itself is considered collateral, the lender must ensure that the property is adequately insured with no risk of a tax lien being placed on the home. When the bill for taxes and insurance premiums is due, the lender will access the extra funds that have been collected in escrow to pay them.

What Determines How Much to Withhold in a Mortgage Escrow?

The amount that goes into escrow varies annually based on tax assessments and insurance adjustments, both of which fluctuate. If the homeowner has not paid enough in escrow to pay the tax and insurance bills, the lender will often cover the shortage and adjust the homeowner’s house payment to reimburse the cost. If there is an overpayment into the escrow account, the homeowner may receive a refund. Some states require lenders to pay interest on escrow accounts, so checking with your lender regarding rates may be beneficial.

Is a Mortgage Escrow Account Required?

Whether or not an escrow account is mandatory depends on the financial institution through which the mortgage is secured. Most lenders will require an escrow account if the borrower puts less than 20% down on the property. Lenders that do not need an escrow account will often drive up the interest rate of the loan for added protection against the risk of loss. Since insurance premiums and tax payments are usually sizable bills to pay all at once, most homeowners find escrow accounts as a convenient way to break these large payments into manageable pieces.

Homebuyers should also be aware that, once an escrow is established, it can be challenging to dissolve. Most of the time, lenders require that the homeowner has at least 20% equity in the home before a cancellation request will be considered. If the homeowner chooses to cancel their escrow account, they are responsible for honoring all insurance and tax payment schedules.

Conclusion – Escrow as a Safety Valve

Think of an escrow account as a safe place for buyers, sellers, and banks. Remember that there are two different types of escrow accounts used for separate actions; one for your mortgage, and the other for the real estate transaction. Escrow accounts protect all parties as they go through what will probably be one of the most significant and complex transactions of their lives.

More Information

Clever connects homeowners with real estate agents in your area that can answer your escrow account questions and more, all for a flat fee of $3,000. If you are thinking of purchasing a home, we can help you make well-informed decisions that will put you in the home of your dreams!

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