What Is Escrow and How Does It Affect the Cost of Buying a Home?
People use the escrow process in the international trade, stock market and, most commonly, real estate arenas. Prospective homeowners go through the escrow process when they close on the sale of a home. But what is escrow and does it add to the cost of buying a home? Keep reading to learn more.
What Is Escrow?
Escrow is a legal process in which parties involved in a transaction appoint a neutral third party. This person will take temporary custody of money, securities or other tradable assets. An escrow agreement reduces risk and ensures both parties meet the conditions of their arrangement.
What Is an Escrow Account?
An escrow account, also known as an impound account, is a holding area for assets that can be traded, such as money or stocks. In real estate, an escrow account is typically used during the purchase process. It can also be used after the transaction, when the “home escrow” or “mortgage escrow” is handled by the buyer’s mortgage company.
The standard escrow definition varies from state to state. Strict rules regulate how financial institutions, such as banks and title insurance companies, establish and maintain escrow accounts, prepare statements, conduct analyses and handle funds in escrow.
In some states, lawyers can establish client trust — or escrow — accounts. Attorneys are also bound by strict rules, including regulations that ensure they never mingle escrow funds with the law firm’s money. They must place the funds in a dedicated bank account that is separate and exclusive. State regulations also pertain to the accrual and/or disbursement of interest accrued in escrow accounts.
How Much Does Escrow Cost?
As with all closing costs, escrow fees can vary considerably by state, as can rules on whether the buyer, seller or both are responsible for paying them. For real estate purchase transactions, escrow services generally cost between 1% to 2% of the home price.
How Does Escrow Work When Buying a Home?
When buying a home, the escrow process unfolds in four major steps:
Two parties engaged in a transaction reach a point where the process can only move forward if each is certain that the other will be able to fulfill their end of the agreement.
The parties agree on a third party to serve as an escrow officer, also called an escrow agent. This third party is often from a bank, a law firm, a title company or the closing company. This varies by state.
The parties agree in writing on the escrow process terms. This includes a closing date, inspection and financing requirements, along with other contingencies.
Once these conditions have been met, the escrow agent handles the disbursement of all monies. This includes realtor fees, mortgage payments, title and property insurance, prorated property taxes, recording fees and any liens. The escrow agent is paid according to state and/or mortgage vendor rules. After that, the account is closed and the three parties have no further obligation to each other.
Escrow services are commonly used in real estate transactions to protect the buyer, seller and lender. Buyers can confidently submit earnest money and other required deposits to an escrow account without risk while details of the sale are still pending.
Buyers are protected because if the seller fails to properly address an issue raised during the home inspection, the earnest money remains in escrow until the seller satisfies the agreement.
Sellers are protected against buyers walking away from the deal at the last minute because, if they do, the seller can claim the earnest money the buyer placed in escrow.
Escrow and Mortgage Lenders
Mortgage lenders also use escrow accounts to ensure buyers pay their property taxes and homeowners insurance.
Generally, homeowners pay one monthly sum to the lender. This includes a portion of the loan’s principal, interest, property taxes and insurance. The lender keeps the tax and insurance payments in an escrow account. They disburse them to the respective companies at the proper time, saving the buyer from having to do this.
The mortgage company adjusts the escrow amounts as property taxes and insurance costs change. An annual statement is sent to the homeowner regarding payments and disbursements made over the last 12 months and the schedule for the upcoming year. After the mortgage is paid off, the homeowner is responsible for making these payments independently.
Final Take
Escrow accounts provide a safe way for two parties to hold assets needed for a transaction. In the process of buying a home, escrow provides an essential safety mechanism that ensures a neutral third party holds the money during the transaction. This allows both parties to meet the agreed-upon conditions and reduces the risk of any misconduct. It acts as a trust-building tool between the buyer, the seller and the mortgage company, as it guarantees that all parties fulfill their end of the deal.
The escrow fee can be a necessary expense to consider when buying a home. It is a small price to pay for the assurance and security it provides during a significant financial transaction like buying a home.
FAQ
Here are the answers to some of the most frequently asked questions regarding escrow.
What does escrow on a house mean?
When you hear the term "escrow" in relation to a house, it refers to a financial arrangement where a third party holds and regulates payment of the funds during the house-buying process. It ensures the sale is completed smoothly, with the third party releasing the funds only after all the terms of the agreement are met.
What is the purpose of an escrow?
The primary purpose of escrow is to protect all parties involved in a financial transaction. It ensures the buyer and seller in a deal meet the agreed-upon conditions before the transaction is finalized, thereby minimizing the risk.
What is escrow and how does it work?
Escrow is a legal concept where a financial asset is held by a third party on behalf of two other parties that are in the process of completing a transaction. The escrow agent holds the assets until all the predetermined contractual obligations contained in the escrow agreement have been completed. They will then distribute the assets to the correct parties.
Do you get escrow money back?
After the real estate transaction is completed, if there is any money left in the escrow account, it would be returned to the buyer. Also, when a mortgage loan is paid off, there might be a balance left in the escrow account that was used to pay taxes and insurance. These funds would be returned to the homeowner. The specifics can vary depending on the terms of your mortgage and escrow agreement.
Chris Ozarowski contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: What Is Escrow and How Does It Affect the Cost of Buying a Home?
