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What Is Escrow And How Does It Work?

7-Minute Read
Published on July 20, 2022
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When you’re buying a home, your lender may require you to put money in escrow or you might hear the term “being in escrow.” Let’s look at an overview of escrow in the real estate process, its purpose, some pros and cons, and finally, some frequently asked questions about escrow.

What Is Escrow In Real Estate?

Escrow is a legal agreement between two parties for a third party to hold onto money or assets until certain conditions are met. Think of escrow as a mediator that reduces risk on both sides of a transaction.

In the case of home buying, it would be the sale, purchase and ownership of a home. When your offer is accepted, you’ll make an earnest money deposit. That money will be held in an escrow account and will be applied to the down payment or – if the contract fails – either given to the seller or returned to the buyer, depending on the circumstances and the terms of the contract.

Once you own the property, your mortgage servicer will create an escrow account for your monthly excess payments and will then pay your annual property tax and homeowners insurance bill when they come due.

How Does Escrow Work?

The purpose of escrow is, at its most basic level, to keep your earnest money secure until all the contingencies in the purchase agreement are fulfilled, and to make sure your taxes and insurance get paid. Let’s take a deeper dive into how this works.

Securing A Home Purchase

Escrow is part of the process to buy a house. After you make an offer on a home, and it’s accepted, you’ll submit earnest money. This is a deposit that shows you’re serious about buying the home. You or your real estate agent will deposit this money into an escrow account while the home buying process takes place.

Once the real estate transaction closes and you sign all the necessary paperwork and mortgage documents, the escrow company releases the earnest money. Usually, buyers get the money back and apply it to their down payment and mortgage closing costs.

Paying Taxes And Insurance

Your mortgage lender may require an escrow account to accompany your loan. They’ll run it for you to help pay your property taxes and insurance. When they calculate your monthly mortgage payment, they add any extra amounts you’ll need, such as for any mortgage insurance premiums.

Your lender will calculate what extra money will be needed for property taxes and for your homeowners insurance. This gets added to your base monthly payment, and each month, this extra amount is deposited into your escrow account. Essentially, you’re paying a little more each month to cover these payments, rather than making huge payments once or twice a year.

When your property taxes and homeowners insurance payments are due, your mortgage servicer will use the money in this account to pay these bills on your behalf. This ensures that you won’t ever pay these bills late, and that your insurance provider and local government won’t place a lien against your house for missed insurance payments (that could lead to an insurance policy lapse) or unpaid taxes.

You’ll most likely have to prepay some of your escrow costs at closing. For example, your mortgage servicer might make you pay upfront for your first year of homeowners insurance. If your policy costs $1,000, typically you’ll have to provide that amount at closing so that your servicer can pay for your first year’s coverage.

You’ll then start funding your second year of coverage, and every year after, as part of your monthly mortgage payments.

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Who Manages Your Escrow Account?

When you enter into a purchase agreement, an escrow account is opened to keep your earnest money secure. It’s generally held by a neutral third party called an escrow company (sometimes it’s the title company), and managed by an escrow agent. This person takes care of the transactions on both ends, to ensure that everything is handled neutrally. They’re in charge of disbursement of escrow payments.

Once you’ve closed on your new home, your escrow account is usually overseen by your mortgage servicer, since the money is used for different things post-closing.

What Are Escrow Fees?

Escrow fees are part of the buyer’s closing costs. They pay for different costs associated with the closing process itself. They cover costs like paperwork fees, as well as distribution of funds to the appropriate parties involved, and to the title company for conducting the closing itself.

Once you’re done with closing and are making mortgage payments, the extra money collected in each mortgage payment is used to pay for your property taxes and homeowners insurance.

Who Pays For Escrow Fees?

During the home buying process, the fees are generally paid by the buyer and seller equally. However, sometimes this can be used as negotiation in the buying process, with the seller paying the fees as a seller’s concession.

This is especially popular when it’s a buyer’s market and the buyer has more purchase power. On the opposite end, if it’s a seller’s market, the seller may negotiate with the buyer for the buyer to pay the fees.

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Pros And Cons Of Escrow

Let’s take a quick look at the benefits and drawbacks of escrow.

Pros

There are some definite advantages to having an escrow account:

  • It protects your deposit when buying a home. If the sale falls through due to something on the seller’s end, you’ll get your money back.
  • You’ll pay a smaller amount over 12 months. You won’t have to worry about paying those big lump sums twice a year.
  • You’ll avoid late payments. Your mortgage servicer will ensure your property tax and homeowners insurance payments get made on time.

Cons

There may be a few drawbacks to think about when considering an escrow account:

  • Your monthly mortgage payment is higher. Because you’re spreading your tax and insurance payments over 12 months, it’ll increase your payment from its base amount.
  • Estimated amounts might be incorrect. When your lender calculates your mortgage payment, they estimate what your property taxes and insurance premiums will cost and use that to calculate your escrow payments. Especially with taxes, when it comes time to pay, what you owe may be different. This can lead to your escrow account having too little in it to cover the expense. Your servicer will conduct an escrow analysis once a year to determine if there’s a shortage. If you’re taxes or insurance of decreased, you’ll get a check back.
  • Your monthly payments may change. Your lender recalculates your payment every year after an escrow analysis. If your property taxes or insurance premiums go up, even those with a fixed-rate mortgage may find their monthly payments increasing.

FAQs About Escrow

Let’s look at a few common questions about escrow.

Is escrow used only in real estate?

No. Escrow is used in many business transactions. For example, if one company wants to buy another, the purchasing company will place good faith money in an escrow account while the company being purchased complies with any information requests needed.

Will escrow cover my housing association (HOA) payments?

No, it doesn’t. Escrow doesn’t cover all the kinds of payments you may need to make, such as HOA fees. That’s because mortgage lenders have a superior claim to HOAs, meaning that if the home goes into foreclosure, your HOA only collects on its lien after the lender is fully compensated.

What does ‘in escrow’ mean?

This is a term used during the home buying process. To be “in escrow” means you’ve got a type of legal holding account. This means that the money and property in the transaction can’t be released until all conditions are met by both the buyer and seller.

Do I get escrow money back at closing?

Generally, your earnest money deposit is applied to your down payment amount or other closing costs. If you’re buying a home with a no-down-payment loan, such as a VA or USDA loan, you’ll be able to apply it to other settlement costs or get your earnest money back at the close of escrow.

Can I stop paying taxes and insurance into escrow?

Often, lenders require new home buyers to make payments into escrow. Many new homeowners enjoy the convenience of making monthly payments toward large annual payments.

But more financially savvy homeowners may resent forgoing the interest they’d earn if they simply deposited the money into their own account monthly. If you have an excellent repayment history, you can ask your lender for an escrow waiver, which, if granted, will lower your monthly mortgage payment and return the obligation of paying property taxes and insurance premium to you.

Speak with your servicer because they may require a certain amount of existing equity to remove an escrow account. For example, you might be required to have paid off 20% of your balance. At

How much is a typical earnest money amount, and do I get it back if the sale falls through?

How much you’ll have to pay in earnest money varies, but it’s usually about 1% – 2% of your home’s final purchase price. If you’ve agreed to pay $300,000 for your new home, you’ll typically have to deposit $3,000 – $6,000 in earnest money into an escrow account.

If your home purchase falls through, you might not get the earnest money returned. For instance, if you change your mind and decide not to purchase the home, the seller typically keeps the earnest money. However, if the sale falls through because a home inspection finds serious problems with the house or it doesn’t appraise for a high enough value, you may be able to receive a refund of your earnest money, with the appropriate contingencies in the contract.

How much will I have to pay upfront for property taxes?

How much you pay upfront to cover property taxes will depend on when your first property tax installment is due. Your lender might require, for instance, 3 months of property tax payments upfront to establish your escrow account.

For example, if your property taxes are $4,800 a year, this means you’ll pay $1,200 into escrow to cover those taxes. This amount is calculated by dividing the $4,800 by 12 (a year’s worth of payments) which equals $400 a month. If your lender needs 3 months of property tax payments, you’ll provide three installments of $400, for a total of $1,200.

The Bottom Line: Escrow Keeps Your Money Safe Until It’s Needed

While escrow can seem like a complicated beast, it protects the buyer and the seller during the home buying process. After closing, escrow is a helpful way for homeowners to make their yearly property tax and homeowners insurance payments on time.

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Hanna Kielar Headshot

Hanna Kielar

Hanna Kielar is a Section Editor for Rocket Auto, RocketHQ, and Rocket Loans® with a focus on personal finance, automotive, and personal loans. She has a B.A. in Professional Writing from Michigan State University.