What is escrow?
Buying a new home can cause hesitation in home buyers and sellers alike. There are many things that can go wrong in the process and this can be stressful. Buyers can back out, sellers can fail to disclose issues with the property — money can be lost. There are ways to safeguard your investments, however. Whether you’re the seller or the buyer, you can be protected, thanks to something called “escrow.” What is escrow? Let’s discuss the escrow meaning and usage in the mortgage process.
What is escrow?
While escrow is used in many applications outside of just mortgage loans, it serves a similar purpose in all regards. What do we mean by “escrow?” Escrow, meaning a legal agreement where a neutral third party stores (typically) large sums of money until a certain process is fulfilled, is a simple breakdown of the situation. Let’s discuss how this is applicable in the mortgage loan process.
What is an escrow account and how does it factor in?
Escrow accounts act as a neutral third party when two companies or individuals conduct a large purchase (such as the purchase of a home). Any funds or assets associated with a sale are held in escrow until all terms of the purchase agreement are satisfied by both parties. Once the sale is complete, the escrow company will distribute those funds according to the agreed upon contract.
For example, if a company in Ohio wants to buy machine parts from a company in China, the two would likely set up an escrow account to facilitate the exchange. While the buyer wants to ensure the quality and timely delivery of the product, the seller needs a guarantee that the buyer’s funds are available. By depositing those funds in an escrow account, the seller is reassured that the payment will be made, and the buyer can be confident they will be refunded in the event of an unsatisfactory delivery.
Similarly, if you wish to buy a home, you and the seller can set up an escrow account to transfer money between the two of you. If, for some reason, the seller doesn’t disclose an issue with the property, you can rest easy, knowing any deposits you made are in escrow and can be refunded to you. Without an escrow account, the seller may decide not to refund those deposits to you. Alternatively, if you, the buyer, backs out of the agreement, the seller knows they are protected by the escrow account.
Whether the sale is completed or falls through, both parties can be certain that the assets held in escrow will be distributed appropriately.
What types of escrow accounts are used in real estate transactions?
There are two common types of escrow accounts used in real estate transactions:
- Home buying with escrow accounts: These accounts are used to store earnest money or other deposits. Earnest money is a deposit made in good faith to the seller to show intent to buy the home. If the buyer defaults on the contract, the seller may get to keep the funds. However, if there is an issue with the property due to the seller or construction work, the funds may be held in escrow until the issue is resolved.
- Taxes & insurance with escrow accounts: This is used when your lender pays certain taxes or insurance fees for you on a monthly basis. Some lenders will roll your PMI payments or property taxes into the lump sum of your mortgage payments. Then, the funds that support the insurance fees and taxes are placed in an escrow account to be distributed on your behalf to the appropriate parties. If your lender collects too much, you will be refunded the difference.
As you can see, escrow accounts can be really beneficial to buyers, sellers and lenders. Now that we’ve discussed the escrow meaning and account usage, let’s talk about escrow companies.
What is an escrow company?
For large transactions involving loans, such as mortgages or supply chain purchases, buyers and sellers would both gain from the added security an escrow account can provide.
During a real estate purchase, the buyer and seller are obligated to provide payments and documentation at different points throughout the course of the homebuying process.
Down payments, titles, appraisal reports and other securities are all exchanged while closing on a new home. Rather than hand these assets directly over to the other party and trust them to fulfill their end of the contractual agreement, buyers and sellers will secure these expenses with an escrow company.
Escrow companies, or escrow agents, are responsible for the protection and eventual distribution of property, funds or assets associated with a large sale.
The assets provided to the escrow company are subject to the escrow agreement, a legal contract made between all three parties that outlines the escrow company’s role and how funds and titles will be allocated upon the close of the sale. This agreement also describes how those assets will be distributed if the sale stalls or falls through.
What are escrow fees?
Escrow companies make money by charging a fee for acting as the third party throughout the transaction.
In a real estate context, these fees are usually a part of the overall closing costs connected to the purchase. Closing costs are the fees associated with a mortgage loan that are paid at the very end of the homebuying process.
Usually amounting to a small percentage of the total loan amount, closing costs typically cover appraisal, credit checks and property taxes in addition to escrow fees.
Escrow fees are an expense paid to the company or agent acting as the neutral third party. The amount is relative to the sales price of the property and can vary widely from sale to sale.
Upon receiving a loan estimate from their lender, the borrower will be able to view a breakdown of all associated costs under the “Projected Payments” section. In addition to estimates on interest and property taxes, this section also highlights the estimated escrow, giving the borrower an idea of what they can expect to pay in escrow fees upon closing.
The person responsible for paying escrow fees can also vary from mortgage to mortgage. Sometimes this cost is shared between the buyer and seller or is backed entirely by one of the two.
What are the benefits of escrow?
While these third-party organizations hold assets until certain thresholds are met, the buyer and seller are both assured that their upfront fees are protected. If obligations cannot be met and the sale should fall through, escrow companies will then redistribute the funds and titles according to their agreement.
Escrow benefits for buyers
When buying a new home, you’ll likely make a good faith deposit on the property to indicate your interest and formally begin the homebuying process.
If you and your seller are able to come to a purchase agreement and deposits are made, those funds will be held in escrow until the sale is finalized. If an issue is uncovered during the home inspection and the sale falls through, you’ll still be able to recover those deposited funds.
If you handed that deposit over directly to the seller, they might decide not to return your deposit if you back out of the sale. Escrows guarantee those deposits are safe throughout the course of the transaction.
Escrow benefits for sellers
Escrow accounts provide equal assurance to sellers during a home sale. If a buyer decides to move forward with the sale, there are a number of payments they’ll need to make before they own the home.
Sellers that require their buyers to hold payments and documents in escrow accounts can be positive that the other party can afford the purchase and help prevent unwelcome surprises from upending a purchase agreement.
Escrow companies help bring large purchases to a close by providing a trusted place for all parties to deposit assets related to the sale.
Escrows in real estate purchases also allow for greater confidence throughout the homebuying process by providing all parties with the peace of mind that funds are available and will be correctly distributed.
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