If you’ve ever come anywhere near the topic of real estate, chances are, you’ve heard the term escrow and wondered exactly what it is, as well as what it’s for.
Well, as mortgage experts, we are here to walk you through, in-depth, everything you need to know about escrow to help make your current or future real estate transaction
The Definition of Escrow
Escrow is a lump sum payment made into an account held by a trusted third party on behalf of a buyer and a seller during the process of completing a transaction, such as a real estate deal.
Once the transaction is complete, the deposit is then released to the rightful party as per the legal agreement.
Escrow is mainly used as earnest money to protect the interested party in the negotiation from not getting paid according to the terms of the agreement.
There are two types of escrow accounts: a home buying escrow account and a property tax and insurance escrow account.
Home Buying Escrow Account
When a buyer purchases a property, the lender will require them to make a minimum deposit into an escrow account as a measure of good intention to purchase the property.
After the deal is complete, the escrow agent will then apply the deposit to the buyer’s down payment, provided there are no exceptions to the transaction, such as there was an issue with the property when the buyer completed their final walk-through, or the buyer agreed to let the seller remain in the home for a short period after the transaction.
When this happens, it is referred to as escrow holdback. Escrow holdback can also occur if you are having your home newly built.
However, once the terms of the agreement are fulfilled, and the construction is signed off on, the deposit will be released to the interested party.
On the other hand, should the buyer default on the agreed-upon terms, the seller will usually be granted the money.
Property Taxes and Insurance Escrow Account
Escrow can also be held in an account so that after you purchase the property, there will be money to pay the insurance and property taxes on the home when they become due.
Since your tax bill and insurance premiums can vary by the year, your loan servicer will calculate your property taxes and insurance payments for the following year using the previous year’s bills.
Most loan servicers will also usually require at least two months’ worth of property taxes and home insurance payments in your escrow account to ensure there are enough monies to pay the bills when they are due.
If, after examining your account annually, the lender discovers there is not enough money in escrow to cover your taxes and insurance, they will require you to pay the difference.
Property owners can do so either by making a one-time lump sum payment or they can have the lender tack on the deficit to their monthly mortgage to cover the bills.
However, if the lender discovers that your escrow account contains more than enough monies to pay your taxes and insurance, they will provide you with a refund.
Who Doesn’t Need an Escrow Account?
There are several instances when a property owner can forgo the escrow account for taxes and insurance.
For instance, if an individual is financially stable, they can pay their own property taxes and insurance out of pocket instead of paying them through an escrow account.
Conventional loan applicants with at least a 20% down payment can also opt out of an escrow account. The same goes for VA loan applicants, provided they have a good credit history and at least a 10% down payment.
Mortgage applicants who wish to pay only their property taxes from escrow may also be able to opt out of the insurance requirements for the account and instead pay the premiums on their own.
Escrow Account Benefits
Benefits for Lenders
Should any damage occur to your property while you are still paying the mortgage and are not covered by home insurance, the lender loses money. Likewise, if you fall behind on your property taxes, it could result in a lien and foreclosure of your home, in which case the lender also loses money.
Therefore, a property tax and insurance escrow account benefit lenders because it ensures both bills are paid, so they don’t lose money.
Benefits for Homeowners
One way that escrow benefits homeowners is that it helps ensure they don’t have to scrape up large, lump-sum payments when it’s time to pay the taxes and insurance. Instead, the payments are made throughout the year via your escrow account, making it easier to meet your obligations.
Having an escrow account also helps eliminate the hassle of keeping track of your payment due dates because your mortgage lender makes sure your tax bills and insurance premiums are paid on time, so you avoid late payments.
Benefits for Home Buyers
For home buyers, the main benefit of an escrow account is that it protects you against breach of agreements during the transaction, such as inspecting the property and discovering a problem with it that prevents you from completing the sale.
Since the deposit is held in escrow, it gives you confidence knowing your money will be refunded as per the agreement instead of just simply trusting the seller to return it to you.
Escrow Account Managers
Who manages your escrow account will depend on which point of the sales process you are in; however, the two main managers of escrow accounts are:
A mortgage servicer manages your escrow account from the close of the sale until the mortgage is paid in full. During this time, they are also responsible for collecting your mortgage payments and keeping records of them.
Your mortgage servicer is often your lender; however, if they sell the rights to your loan, then the new owner of your loan becomes your mortgage servicer.
Escrow Agents and Escrow Companies
During the initial home buying process, your escrow is held by either an escrow agent or an escrow company. However, the escrow agent or escrow company is sometimes also the title company.
The escrow company or agent also does not necessarily manage the escrow deposit, but it is responsible for safekeeping the documents related to the property sale, such as the deed.
The escrow company or escrow agent also works for both the buyer and the seller.
Issues That Can Affect Your Escrow Account
Upon first moving into your home, your property will be revalued, which could increase your property taxes if its worth has gone up.
This, in turn, can affect your escrow because if your deposit is not enough to cover the increased cost, it will leave your account short. Therefore, you will be responsible for paying the difference.
In fact, it is not uncommon to experience a significant increase in property taxes for at least the first two to three years after living in your home. However, after this time, the bill usually levels out.
Should your lender sell your loan to another mortgage servicer, it won’t necessarily affect your escrow, but it can increase your fees, so be sure to ask your lender if they sell their loans or keep them in-house.