What is Escrow and How Does It Work

Escrow and Earnest Money Deposits Explained

The term "escrow" will often come up when you are buying a home. But what does it mean, and how will this affect you during a home transaction?

Escrow is the situation when a third party is used to hold onto money or property until a certain condition is met. Escrow funds could be held in an account controlled by a third party to protect both the buyer and seller.

Escrow can also be used to make sure property taxes and insurance premiums are paid. The most common use of escrow is earnest money when buying a home.

Using Escrow Accounts in Real Estate Transactions

There are a couple of reasons to use escrow when buying a home. When you have made an earnest money deposit, these funds can be controlled by a third party until the conditions of the sale have been met and the money is released. The most common third party who holds escrow deposit funds is the listing real estate company.

Escrow funds can also be used when you have bought the home with a mortgage. The money to pay property taxes and insurance can be placed in escrow by the lender.

Let’s look at these situations in more detail.

Escrow for Earnest Money

To show the seller that you are serious about purchasing their home, a good faith deposit is required. This is often known as an earnest money deposit and will be kept in escrow until the transaction is complete.

It will be released either during closing or if the sale falls through. If the sale's failure is the fault of the purchaser, the seller will get this deposit. There are also likely to be contingencies allowing the buyer to walk away from the deal with this deposit returned to them. Both buyers and sellers ask all the time who gets to keep the earnest money deposit. The answer really depends on who has breached the contract.

Having this money kept in escrow protects both the buyer and the seller. If the sale progresses as planned, this earnest money will add to the down payment.

There are some situations where money can be held in escrow after the sale has closed. This is known as escrow holdback and could happen if it has been agreed that the seller can stay on in the home for longer, for example. Escrow holdbacks are also used when there are incomplete items as part of the sale.

For example, if the seller left a bunch of personal property behind, and the buyer did not want it, it would need to be removed. It would be the seller's responsibility to do so. In order to ensure they uphold their responsibility of removal, an escrow would be set up that holds some of the seller's closing proceeds. Doing so would give the seller incentive to get their money by taking care of the removal of unwanted items.

Having this money in an account that is controlled by a third party ensures that you will be treated more fairly during the home buying process. If you had simply given the earnest money deposit to the seller, you might run into problems should you try to get it back if the deal falls through.

Tax and Insurance

Your lender, we all use some of your monthly mortgage payments to pay property taxes and insurance. This money will be held in escrow until they are due to be paid.

Since tax and insurance premiums can change, you could find that you have over or underpaid the amount required. While your lender will assess the amounts you need to pay each year, you could still find that you have money owed when the bills are due to be paid. This may mean you have to increase your monthly payments or pay an extra one-off bill.

It is also possible that you have overpaid. If you find yourself in this fortunate situation, the lender will give you a refund. To cover these variations in tax and insurance bills, your lender may require you to put several months of extra payments in the escrow account.

It can sometimes be possible to avoid this situation entirely by dealing with taxes and insurance yourself. You just need to have a lender that allows you to do this. Doing so will reduce your monthly mortgage payments, but you will still need to have the money ready to pay tax and insurance when it is due.

Having your lender deal with these payments can make things a lot easier for you. It will mean that you don't have to worry about when these bills are due and ensure that you don't make late payments. This arrangement also benefits lenders, ensuring that they don't lose out if you forget or are late on payments.

The downside of this arrangement is that you could face a bill if the estimate is wrong. The previous year’s tax and insurance bills are used to create an estimate, and if there is a significant change in that time, you could face a large and unexpected bill.

There can also be an issue when you first move into the home, and it is reassessed for taxes. If the amount that is due increases a lot, there won't be enough funds in the escrow account.

Closing Thoughts on Escrow Funds

Escrow is useful to protect you when you buy a home and also helps make sure you pay taxes and insurance premiums when they are due. While you can sometimes avoid this arrangement for your taxes and insurance, it isn't necessarily a great idea.

Hopefully, you have gotten something out of the purpose of having escrow and now understand it better.