Buying a home comes with plenty of unfamiliar terminology, and escrow is one of those words you’ll hear frequently throughout the process.
So, what is escrow, and why is it important when buying a home?
In simple terms, escrow is an arrangement in which a neutral third party holds money, documents, or other assets until specific conditions of a transaction have been met. In real estate, escrow can help protect both buyers and sellers while a home purchase moves toward closing.
There is also another type of escrow you may encounter after becoming a homeowner: a mortgage escrow account used to help pay certain property-related expenses.
Let’s take a closer look at both.
What Is Escrow When Buying a Home?
After a seller accepts an offer, funds associated with the transaction may be placed into escrow.
Rather than the buyer giving money directly to the seller, a neutral third party holds the funds until the requirements of the purchase agreement have been satisfied.
One common example is earnest money.
Earnest money is a deposit a buyer may make after an offer is accepted to demonstrate their commitment to purchasing the property. Instead of going directly to the seller, the money is generally held by an escrow or other authorized third party until it can be properly distributed according to the purchase agreement.
Other funds and documents related to the transaction may also be handled through the closing or escrow process.
How Does Escrow Protect Buyers and Sellers?
Understanding what escrow is becomes easier when you consider its purpose.
The neutral third party doesn’t represent either side’s financial interests in deciding who should receive the money. Instead, the escrow holder follows the instructions and terms governing the transaction.
This helps prevent funds from being distributed before the required conditions have been satisfied.
For example, the buyer doesn’t want their earnest money immediately handed over to the seller before the purchase is complete. Likewise, the seller wants confidence that the buyer is committed to moving forward with the transaction.
Escrow creates a process for holding and eventually distributing those funds appropriately.
What Happens to Earnest Money if the Sale Falls Through?
A common misconception is that the seller automatically keeps the buyer’s earnest money if the buyer decides not to purchase the home.
That’s not necessarily the case.
What happens to earnest money depends on the purchase agreement, applicable contingencies, deadlines, and the reason the transaction didn’t close.
For example, a buyer may have protections related to financing, an inspection, appraisal, or other contingencies written into the agreement.
Because every transaction is different, buyers should review their purchase agreement carefully and ask their real estate professional questions about when earnest money could be refundable or forfeited.
Who Manages Escrow?
Depending on the location and transaction, escrow may be handled by an escrow company, title company, attorney, financial institution, or another qualified third party.
The escrow holder follows the instructions associated with the transaction and helps make sure funds and documents are distributed to the appropriate parties when the required conditions have been met.
Who pays escrow or settlement-related fees can depend on local practices and the terms negotiated between the buyer and seller.
What Is an Escrow Holdback?
Sometimes a real estate transaction is ready to close even though a specific issue with the property hasn’t been completed.
In certain circumstances, an escrow holdback may be used.
With an escrow holdback, a portion of the funds is temporarily held after closing until an agreed-upon requirement is satisfied. For example, funds might be held until certain repairs or improvements are completed.
Escrow holdbacks aren’t available or appropriate in every situation. They may also be subject to lender, loan program, appraisal, and other requirements.
If a potential issue comes up before closing, your mortgage and real estate professionals can help explain what options may be available.
What Is a Mortgage Escrow Account?
When someone asks “what is escrow?”, they may actually be referring to the escrow account associated with their monthly mortgage payment.
This is different from the escrow used during the purchase of a home.
A mortgage escrow account is generally established and managed by your mortgage servicer to help pay certain property-related expenses.
Instead of paying these large bills separately when they’re due, a portion of the estimated annual cost is included with your monthly mortgage payment and placed into the escrow account.
Your servicer then uses those funds to pay eligible bills when they become due.
What Does a Mortgage Escrow Account Pay For?
A mortgage escrow account commonly helps pay expenses such as:
- Property taxes
- Homeowners insurance
Depending on your loan and property, other eligible expenses may also be included.
Your monthly mortgage payment may therefore include more than principal and interest. If you have an escrow account, part of your payment goes toward the estimated cost of taxes and insurance.
Can Your Escrow Payment Change?
Yes.
Even if you have a fixed-rate mortgage, the total amount you pay each month can change if your property taxes or homeowners insurance premiums change.
Mortgage servicers generally review escrow accounts periodically and compare the amount being collected with the expected cost of upcoming bills.
If taxes or insurance costs increase, the amount collected for escrow may also increase. If there’s a shortage or surplus in the account, your servicer will provide information about how it will be handled.
This is why homeowners with fixed-rate mortgages can sometimes see their total monthly payment change even though their mortgage interest rate hasn’t changed.
Do All Mortgages Require an Escrow Account?
Not necessarily.
Whether an escrow account is required can depend on your loan program, down payment, lender requirements, and other factors.
Some borrowers may have the option to pay property taxes and homeowners insurance directly rather than through their mortgage payment. Others may be required to maintain an escrow account.
Your mortgage professional can explain what applies to your particular loan.
What Is Escrow? The Simple Answer
So, what is escrow?
During a home purchase, escrow provides a neutral place for certain funds and documents to be held until the requirements of the transaction are satisfied.
After closing, a mortgage escrow account may be used to collect money throughout the year to pay expenses such as property taxes and homeowners insurance.
Although the two serve different purposes, both are designed to make important financial obligations associated with homeownership easier to manage.
Have Questions About the Homebuying Process?
Terms like escrow, earnest money, pre-approval, appraisal, and closing costs can make buying a home feel complicated, especially if you’re purchasing for the first time.
At Strategic Mortgage Solutions, we’re here to make the financing side of homeownership easier to understand. We’ll explain your mortgage options, answer your questions, and help you know what to expect throughout the process.
If you’re thinking about buying a home and have questions like “what is escrow?”, you don’t have to figure it out alone.
Contact Strategic Mortgage Solutions today to discuss your home financing options and get started.
