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What Is Escrow And How Does It Work?

6-Minute Read
Published on July 20, 2022
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One of the most common terms you might hear when buying a home is escrow. Your lender may require you to put money in escrow, you might hear the term “being in escrow” and you may wonder what escrow is, exactly. 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.

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Escrow Meaning 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.

An escrow account is basically a savings account that’s managed by your mortgage servicer. When you make a mortgage payment, your servicer deposits a part of each payment into your escrow account to cover your estimated property taxes and your homeowners and mortgage insurance premiums. 

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What Is The Purpose Of Escrow In A Mortgage?

The purpose of escrow is, at its most basic, to show you’re serious about buying a home, and to make sure your taxes and insurance get paid.

Securing A Home Purchase

Escrow is part of the process to buy a house. After you make an offer on a home, and that offer is accepted, you’ll offer 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.

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.

Paying Taxes And Insurance

Your mortgage lender usually requires 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.

Then 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 lender 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 lender 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 lender 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.

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.

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How Does Escrow Work In Real Estate?

As stated above, escrow in real estate is a gesture of good faith between a mortgage lender, the borrower and the seller, so that everyone is protected in the transaction. Let’s look a little more closely at the different factors that go into this concept.

Who Manages Your Escrow Account?

When you enter into a purchase agreement, your escrow account is opened to keep that money secure. It’s generally held by a neutral third party called an escrow company (sometimes it’s the title company), and it’s handled by an escrow agent. This person handles 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 managed by your mortgage lender, since the money is used for different things post-closing.

What Are Escrow Fees?

Escrow fees are part of closing costs. They pay for different costs associated with the closing process itself. They cover costs like paperwork fees, 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 for 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 part of seller’s concessions.

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.

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 for taxes and insurance, rather than big lump sums.
  • You’ll avoid late payments! Your mortgage lender 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 monthly payments may change. Your lender recalculates your payment every year after an escrow analysis. If your escrow amount was too little in the previous year, your payment will likely increase to cover the shortage.
  • Escrow doesn’t cover all the kinds of payments you may need to make, such as HOA fees. You’ll have to cover those yourself.

FAQs About Escrow 

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

What is escrow on a house?

This is a legal agreement between a buyer and a seller where a third party holds money or a property until conditions have been met by both parties.

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?

It depends! At the close of escrow, you’ll likely get your earnest money deposit back. Generally, this is applied to your down payment amount or closing cost amount. However, if you have a loan with no down payment and there’s a surplus of your earnest money deposit, you may get a check.

The Bottom Line

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. Are you interested in buying a home? Apply online today!

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Michelle Giorlando

Michelle Giorlando is a freelance writer who lives in metro Detroit. When she's not writing about homeownership, finances, and mortgages, she enjoys performing improv, gardening, and befriending the wildlife in her yard.