What Is Escrow And How Does It Work?

I’m sure you’re like most people when they hear the word “escrow”…you just nod, smile, and pretend you understand, right?  Well, it’s finally time you know exactly what escrow means.

You’re going to want to read this blog post so you can now participate in those conversations and also understand what it is when buying and selling your home!

What Exactly Is Escrow?

When you’re buying a home, there are a lot of things that need to happen in a specific order. One of the most important is the escrow process. Escrow is a way to protect both the buyer and the seller during the home buying process. In this video, we will explain what escrow is and how it works!

When you enter a purchase agreement in a real estate transaction, you may be required to pay an earnest money deposit. This is an upfront sum provided by your down payment that demonstrates to the seller that you are serious about purchasing the property.

To protect both the buyer and the seller, the money is held in an escrow account managed by an independent and trusted third party until it’s time to close on your home.

Why do both parties need to be protected? 

When a seller accepts an offer, the property goes off the market. If the buyer backs out, the seller is generally entitled to keep the earnest money as compensation.

If the seller does not fulfill the terms of the contract, or can’t deliver the property in nearly the same condition as it was when the transaction was closed, the buyer’s earnest money would be reimbursed, freeing him or her from your contract.

The escrow officer or agent follows through on these agreed-upon terms and provides the funds to the appropriate party.

what is escrow

How Does Escrow Work?

The escrow account is utilized to store money for the down payment and closing costs, credits from the seller, and any other funds that are part of the transaction in addition to the earnest money.

When the purchase agreement is completed, the escrow holder will give you all of the money that is specified in the real estate and mortgage documents. This includes money for your real estate agent, costs associated with getting the loan, costs related to title and insurance, HOA dues, and any other charges that are shown on your final Closing Disclosure

The escrow agent meticulously follows the terms of your real estate contract and your lender’s written instructions to ensure that all money reaches its intended destination.

Escrow Types

Escrow accounts are common in real estate and are used widely in other business transactions, as well.

There are two types of accounts that are typically used when buying or selling a house.

As detailed above, the first type of escrow account is used to manage the money when you buy a home.

The second type of escrow is a mortgage escrow account.

A mortgage escrow account is started when you get a loan. It lasts for the life of your loan.

With a mortgage escrow account, you pay your lender each month for your property taxes and homeowners insurance.

This money is added to your monthly mortgage payment and is held by the mortgage company. The company pays your property taxes and homeowners insurance when they are due.

Escrow accounts are usually required when you borrow more than eighty percent of the money to buy a home. This makes it easy for first-time buyers to budget because their monthly payments will be automatically taken care of.

taxes and insurance

Taxes And Insurance

Many mortgage lenders require you to make monthly payments to cover your taxes, home insurance, and private mortgage insurance.

Your mortgage servicer estimates how much it will cost you to pay for your expenses every year. You then have to pay one-twelfth of that amount every month. For example, if your annual insurance premium is $1,200, you would have to pay $100 each month.

Your escrow agent sends the money to the right people when bills come due. After you pay off your mortgage deed (sell your house), you get any extra money back.

What Escrow Doesn’t Cover

Escrow can be helpful when you are buying a home. It is a way to save money for the bigger costs of owning a home. But be careful. It will not cover everything.

Here are just a few expenses your escrow account won’t pay for:

Utility bills: Your escrow account will not cover your electric or water bills. But your taxes from your local utility district might be covered.

HOA fees: If you get a bill for HOA, POA, or community-based dues, make sure to pay it by the deadline to avoid any penalties.

Supplemental tax bills: These taxes are different from your regular property taxes. They might be taxes for a new home addition, or for when the value of your home changes. Usually, these aren’t paid for by escrow.

businessman thinking about money, close up

Pros And Cons Of Escrow

Here are the advantages and disadvantages of escrow payments.

Pros

Protects buyers and sellers: Sometimes, when the seller accepts the buyer’s offer, the sale does not happen. This is because an account called an escrow account keeps track of every transaction and makes sure both parties get a fair deal.

Budget for ongoing costs: Making monthly escrow payments will help you budget for your annual property taxes and insurance bills.

Ensure bills are paid on time: If you keep your tax and insurance money in an escrow account, you don’t have to worry about missing any payment deadlines. Your mortgage lender will automatically take the money from the escrow account and pay each bill for you.

May earn interest: Some states allow your escrow balance to earn interest. The amount of interest earned varies depending on the bank and state.

Cons

Higher monthly payment: Your mortgage payment might be more than what is shown on your loan estimate. This is because the loan estimate usually just calculates the principal and interest payments. Make sure to include property taxes and insurance costs when shopping for a home.

Fluctuating payments: Escrow holders periodically analyze the projected costs for the next 12 months. This means that your monthly escrow payment may go up or down multiple times during the loan’s repayment period. This can make it hard to budget for housing costs.

Incorrect payments: Sometimes, your escrow company might forecast an inaccurate payment amount. If this happens, you might need to make a lump-sum payment to avoid an escrow shortage. If you’re overpaying, though, you might get a partial refund.

Upfront deposit: Most lenders require two months of escrow payments when you close. This is in addition to your down payment and closing costs.

Escrow Example

When you buy a home, you might put down earnest money to show that you are serious about the purchase. This money is usually between 1% and 3% of the purchase price. So, on a $350,000 home, you would put down at least $3,500.

Monthly escrow payment example: If you have a monthly homeowners insurance premium of $150 and a monthly property tax bill of $200, your monthly escrow payment will be $350. At closing, your lender will likely require you to pay two months of escrow reserves upfront. In this case, that would be $700.

If your taxes or insurance premiums go up or down, your monthly escrow payment may go up or down. But if you have a fixed interest rate, your mortgage payment will stay the same.

money rolls

How Long Do You Pay Escrow?

Most mortgage lenders require that you pay for escrow for the life of your loan. This is a way to make sure that you always have money to pay your property taxes and insurance. However, if you have private mortgage insurance premiums, you can ask to stop paying them once you reach 20% equity in your home.

Tip: If your mortgage is at least a year old, you may be able to cancel your escrow account and lower your monthly mortgage payment. This is possible if you are comfortable paying your own insurance and taxes. To find out if you qualify, contact your servicer.

Are Escrow Accounts Required?

Most home loans have escrow requirements. This means that your monthly payment will be higher, but it is worth it because it spreads the cost of your taxes and insurance out over time.

Another advantage of using a property management company is that they can help you stay on top of your payment deadlines. This can be helpful because it eliminates some of the hassles that come with homeownership. Additionally, you don’t have to worry about keeping track of those deadlines yourself.

If you’re shopping for a home loan, compare the rates from multiple lenders before choosing one.

contract negotiation what is escrow

Frequently Asked Questions

How often do escrow payments change?

Escrow holders periodically analyze the projected costs for the next 12 months. This means that your monthly escrow payment may go up or down multiple times during the loan’s repayment period.

What if I’m overpaying on my escrow account?

If you’re overpaying, you might get a partial refund. However, it’s important to note that most lenders require two months of escrow payments when you close. So, even if you have a surplus in your account, you’ll still need to pay this amount at closing.

Can I stop paying escrow once I’ve hit 20% equity in my house?

Yes, if you have private mortgage insurance premiums, you can ask to stop paying them once you reach 20% equity in your home. However, most mortgage lenders require that you pay for escrow for the life of your loan.

How do I know if I qualify to cancel my escrow account?

To find out if you qualify, contact your servicer. Generally speaking, you need to have a mortgage that is at least a year old before you can cancel your escrow account. Additionally, you must be comfortable paying your own insurance and taxes. Canceling your escrow account can lower your monthly mortgage payment.

What happens if I don’t have enough money in my escrow account to cover my property taxes or insurance premiums?

If you don’t have enough money in your escrow account to cover your property taxes or insurance premiums, you will be responsible for paying the difference. This can put you at risk of defaulting on your loan, so it’s important to stay on top of your escrow balance. You can make additional escrow payments throughout the year to help keep your account balance healthy.

Final Thoughts

Escrow is a vital part of the home buying and selling process. It protects all parties involved in the transaction by ensuring that all documents are signed, funds are delivered, and titles are transferred properly. If you’re ready to buy or sell a home, reach out to us to start the ball rolling. We’ll take care of everything for you so that your escrow experience is as smooth as possible.

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