What Is Escrow Explained: A Guide to Understanding Escrow in Real Estate
Simply put, escrow is a term that refers to a financial arrangement in regard to real estate.
Throughout this article, we will be tackling what an escrow account is, how it affects your mortgage payments, escrow balances and shortages, and the pros and cons of having an escrow account.
What is escrow and an escrow account in real estate?
If you’re a home buyer or seller, being in escrow means different things:
- As a buyer, you are agreeing to pay a fraction of the price of the property into escrow for safekeeping.
- As a seller, you are agreeing to remove the house off the property market whilst it is in escrow and allow the home to be viewed for inspections ahead of the sale closing.
Where mortgages are concerned, escrow and escrow accounts refer to two different concepts.
Escrow refers to when a potential homebuyer reaches the transactional part of purchasing their new home. It is the financial arrangement in which two parties use a third-party (who is neither the buyer nor the seller) to temporarily hold money, paperwork, or other assets for a transaction on their behalf.
The purpose of this is to give reassurance to both the buyer and the seller in the case of a transaction where a large amount of money (often the earnest money deposit or down payment) or other assets is involved, and there are a number of obligations that need to be fulfilled before payment is released.
An escrow account functions as a savings account that is often managed by your mortgage provider. Your mortgage provider will deposit a portion of each mortgage payment into your escrow account to cover your estimated real estate taxes and insurance premiums. We’ll go into this in more detail shortly.
How do escrow accounts work?
When you own a home, you’re responsible for additional home-related expenses like property taxes and insurance. When you obtain a mortgage loan from a bank or direct lender, you also receive an escrow account that helps you pay these additional payments on time.
Even though these costs are paid on an annual basis, an escrow account is one that you fund each month, and the expense payments will be made from this account when they are due.
Many people find having an escrow account a much easier way to manage additional expenses. This is because setting aside money every month is often easier than trying to find the money for lump-sum payments throughout the year.
Plus, when these bills are due, they’re paid on your behalf.
What is escrow used for on a house?
Escrow is used on a house sale for security to fulfil a number of commitments on behalf of both the buyer and the seller before the transaction is completed.
When you’re buying a house and the seller has accepted your offer, escrow opens (please refer to the opening escrow heading for full details), and the buyer places all of their obligations into escrow.
With the deposit/down payment in escrow, it is the seller’s time to complete the obligations needed.
How does escrow work on a mortgage?
Escrow plays a role in both your initial home purchase and the ongoing monthly mortgage payments that follow.
An escrow account is used to make mortgage payments easier by streamlining multiple bills into one place. An escrow account helps to manage a mortgage borrower's annual tax and insurance costs, such as flood insurance, for example.
When you make your total monthly house payment, part of it goes toward your mortgage to pay your principal balance and interest and part of it goes into your escrow account to pay your taxes, homeowners’ insurance, and any other expenses.
The amount you pay into escrow is calculated with three things: property taxes, insurance premiums for your home, and the minimum balance you need to keep in your account.
- First, the amount you’ll owe over 12 months for your property taxes, homeowners’ insurance, and any other expenses—such as mortgage insurance or flood insurance—is estimated. This number is calculated on your behalf from loan closing documents, the local property tax office, and the insurance company, so you won’t need to provide any of those things.
- Then the mortgage portion (or principal payment) is added to make one combined payment. This way, you’re setting aside money for escrow each time you make a monthly mortgage payment.
- Finally, a minimum balance is calculated. This is to help you plan for any potential increases and can be a sum of up to two months of escrow payments.
What is an escrow payment?
Each month, you’ll make one combined payment that will go toward your principal mortgage payment and your escrow.
Although the taxes and insurance that come from your escrow account are often annual payments, you will pay them into your account in equal monthly payments. When your taxes and insurance are due throughout the year, the funds are withdrawn and paid on your behalf.
What is escrow shortage?
An escrow shortage refers to any time when your escrow account balance falls below a minimum required level.
In addition to a shortage, there’s also a status called an escrow deficiency. This is when you don’t have enough money in your escrow account to pay for all your escrow items, like taxes and insurance.
If that’s the case, you end up with a negative balance in your account and your mortgage lender will provide the difference of what is due. You’ll end up paying this back when your next escrow analysis is conducted.
An escrow analysis is a review of your escrow account required by federal law and conducted by the mortgage provider before the opening of the account and then every year after that. Your provider is required to send you a statement outlining the details of the review once it has been conducted.
When you have received your escrow statement, the monthly price may have risen for the payments in the following year. This is because property taxes and insurance premiums for your home can change each year, and there needs to be enough in your escrow account for when these bills are due.
What is an escrow balance?
Each monthly payment is often formed of a principal payment, interest payment, and an escrow payment.
The escrow balance is the amount that is currently in your escrow account just for your property taxes and insurance and differs from your principal balance.
A principal balance is the amount of money still owed on the loan for the property and does not include interest or any other fees or charges.
What does it mean to open escrow in real estate?
When a buyer agrees to purchase a home from a seller, the agreement is taken to a title company to complete the transaction process. This is called “opening escrow.”
An earnest money deposit is the first financial transaction to take place through escrow and shows the seller that you are serious about the purchase.
By making this payment to an escrow rather than to the seller, you can be confident that if there are any unexpected problems, you will receive your money back.
Similarly for the seller, if there were to be any unanticipated circumstances from the buyer, that money is being held by a title company.
Escrow opens when a signed agreement is delivered to an escrow officer, who ensures that the conditions of the contract are all satisfied.
For example, the officer might confirm that home inspections, disclosures, and concerns are completed or settled on time and then the process can proceed.
The time it takes to go from the start to the end of the escrow process differs, depending on a number of factors. Some things that effect the time it takes to close escrow are the following:
- Mortgage pre-approval
- Having the proper documents on hand and ready to be processed
- The amount of time it takes to get the underwriting complete.
The steps, however, are generally the same for everyone.
Escrow then closes when each party has completed everything they agreed to do, and the homeownership is transferred to the buyer.
What is an escrow agent?
The escrow agent is a neutral person or entity who is entrusted with holding payments until the requirements mentioned above have been met.
You will usually not be responsible for securing your own escrow agent as your broker or lender will facilitate the process. However, in a real estate purchase, the title company would usually be the escrow agent.
Your escrow agent will trace and confirm the transfer of key variables: most notably, the transfer of the property title from the seller to the buyer and the move of funds from the buyer to the seller. It also helps to assure the lender that the loan money is going to the right place.
What are the pros and cons of having an escrow account in real estate?
There are a number of pro and cons to having an escrow account in real estate, and it can come down to personal preference.
Pros of an escrow account
An escrow account enables you to make the payments toward your taxes and insurance in monthly instalments rather than having to make a big expenditure when these bills are due.
This is a pro to many people as it provides a level of convenience because you don’t need to plan for big bills.
No hassle payments
As payments are made on your behalf through your escrow account, there is no need to worry whether the payment has been completed.
Lower mortgage costs
You may be eligible for discounts on your interest rate and/or closing costs by choosing an escrow account.
No extra funds each month
There is no need to set aside extra funds each month as the exact amount needed for taxes and insurance will be automatically added to your monthly principal and interest mortgage payment.
Cons of an escrow account
Funds are tied up
If you are great at saving money and confident you can make the payments, you can decide to keep control of your homeowner’s insurance and taxes until the bills are due.
This enables you to earn interest on those funds in a savings account, which an escrow account does not provide.
Upfront account set-up
You may be required to deposit several months of property taxes when you open the account. However, this is dependent on the time of year.
Property taxes and insurance change regularly as costs fluctuate. When this happens, you could end up with an escrow shortage.
On the other hand, you could end up with an escrow surplus. This occurs when you paid more into your escrow account than you had to in the previous year.
This most commonly occurs if your property value has gone down enough to change your tax assessment or if you switched to a cheaper homeowner’s insurance policy.
If you have a shortage in your escrow account, you’ll have to pay it back, but there are a couple of options to do so. You can either pay off the shortage in full with a one-time payment applied directly to your escrow account, or you can pay off the shortage over the following 12-months.
Alternatively, your escrow balance may be in credit (known as an escrow overage) as the account is projected to have more funds than needed to pay your taxes and premiums, and you will likely receive a refund for that amount.
The escrow system follows a step-by-step process that makes transactions speculation-free. Both the buyer and the seller can follow the progress of funds and track the progress of the contractual commitment.
Since the transactions are conducted under the supervision of professionals, buyers’ funds and sellers’ offerings remain in secure hands.
Escrow accounts, similarly, are there to make mortgage payments easier and should be utilized.
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