What Is Escrow and Why Is It Needed?

Homebuyers, especially first-time homebuyers, may not fully understand the issue of escrow and how it relates directly to a home purchase.

But understand it they should, as escrow plays a vital - and protective - role in the home-buying process and thus needs to be thoroughly understood by homebuyer and seller alike.

What Is Escrow?

While escrow is typically linked to real estate, it can extend to other major financial transactions.

In a major financial transaction between two parties, escrow is defined as an impartial third party that holds a valuable asset (usually cash) until the transaction is complete.

Mainly, there are three types of escrow - real estate escrow, online escrow and escrow accounts:

Real estate escrow

Mortgage lenders typically insist on a real estate escrow account for the buyer prior to the purchase, before any home inspection or disclosures on the home's condition are completed. Once the buyer and the lender knows the property is in satisfactory condition, the money from the escrow account is released on the home purchase closing date.

Escrow account

An escrow account is used after the buyer moves into the home, as the mortgage lender pays money owed on property taxes and homeowners insurance out of the escrow account, funded by the buyer.

Online escrow

Consumers doing business online use online escrow to provide a measure of protection on a digital purchase of a product or service. The escrow model works the same way, as the money is kept in an escrow account by a trusted third party, until the conditions of the purchase agreement are satisfied by both the buyer and seller, and the escrow money is released.

Real Estate Escrow Process

During the home sales process, the buyer puts up a predetermined amount of cash (usually between 1% and 3% of the total home sales price) in an escrow account after an offer is accepted by the homeowner, and is held by a bank or other financial institution in an escrow account until the sale is finalized. This is what real estate and mortgage professionals refer to as "being in escrow." Expect the home sale escrow process to last about 30 days - or the time it takes to fully sign off on the home sale between both parties and the mortgage lender. The homeowner doesn't get access to the money during escrow and the amount of cash put into escrow by the homebuyer is applied to the overall home sales price once the deal is finalized.

Escrow After Home Purchase

After the home is purchased, the buyer also used an escrow account to pay property taxes and home insurance charges incurred as a homeowner. The mortgage loan servicer makes these payments for you, and has direct access to the escrow account. Mortgage lenders prefer escrow accounts especially for property tax payments, as they don't want the property, backed by their mortgage loan, to fall behind in taxes and risk a tax lien on the property. The same thinking applies to homeowner's insurance, where the lender can't afford the homeowner to miss payments, and thus risk losing insurance coverage on the property.

For homeowners dealing with an escrow account, a good rule of thumb is to expect to pay two months' worth of expenses on an escrow account at the home sale closing. Typically, once per year your mortgage lender will review your escrow account to make sure you have sufficient funds in your escrow account to cover property tax and home insurance payments.

How to Get Professional Escrow Help

While home sale escrow accounts aren't all that complicated, it's advisable for both parties to agree to a professional title agent, real estate lawyer or a mortgage loan servicer to handle the escrow process. Your real estate agent can direct you to a qualified escrow professional.

Earning interest on an escrow account

There's no federal law guaranteeing financial institutions to pay interest on the money held in an escrow account. However, a growing number of states - including Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont and Wisconsin - do require banks and financial institutions holding escrow payments to pay interest to account holders.

Is not having an escrow account acceptable?

You can avoid an escrow account after a home sale (having an escrow account active while the home sale is completed is mandatory, however), but only under certain conditions. For example, if you put 20% cash down on your home, the mortgage lender may waive an escrow account, but could charge a significant fee for doing so. In general, mortgage lenders want to be sure those property tax payments and homeowner's insurance payments are on hand, in good order, and readily accessible for payments. Lenders can make it difficult to avoid an escrow account after a home purchase.

Are Escrow account totals fixed?

Escrow accounts aren't fixed. The amount of money held in an escrow account may vary, most notably due to fluctuations in local property tax assessments, which can and do move up and down during the time the homeowner is repaying his or her home mortgage loan. Additionally, if you pay off your homeowner's insurance early or if your home declines in value, your escrow payments can decline, as well.

Escrow account fees

There are fees linked to escrow accounts. Typically, an escrow agent will charge a fee of about 1% of the home sales price for handling the escrow account, paid at the home sale closing. The homebuyer and seller can negotiate who winds up paying the fee, or whether the buyer and seller will wind up splitting the fee.

After a home sale, it's up to the new homeowner to make sure his or her escrow account has enough cash to cover property tax and homeowner's insurance payments. The homeowner should expect the mortgage lender to be directly involved to make sure escrow payments are being made - and on time.

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