During the home buying process, escrow is a term commonly discussed. Yet, it can be confusing to buyers and sellers.
Understanding what it is, its purpose, and how escrow works will help you better manage the process of buying a home. You’ll also have greater peace of mind and confidence that you’re making the right choices for yourself when purchasing a house.
What Is an Escrow Account?
Escrow is a legal term where a third party will oversee money or assets for two parties until the transaction meets the conditions of the contract. It essentially allows a neutral party to mediate a large transaction to reduce the risk for the two parties involved if the transaction doesn’t go through.
In real estate, escrow protects the interests of the buyer and seller when transitioning a house from the seller to the buyer.
Two Types of Escrow Accounts When Buying a Home
In real estate, there are two potential types of escrows that a homebuyer may use. The first type of escrow occurs during the home buying process, while the second type occurs after the sale.
1. Escrow for buying a home
When a buyer’s offer is accepted, the buyer often sets aside a specific amount of money as a good-faith deposit to indicate the buyer is serious about owning the home. This money is often called earnest money.
The earnest money is managed by a neutral third party until the sale of the house is complete per the contract’s conditions. An escrow deposit account holds the earnest money. Neither the seller nor buyer has control of the money during this time.
This type of escrow is only for the short term. Once the contract conditions are met and the transaction is complete, the money will be released back to the buyer. This money is then applied to the down payment and closing costs.
However, if the sale of the home falls through due to the buyer, the seller will likely receive the earnest money. If the house doesn’t sell because of the seller, the buyer will typically receive the money as a refund.
2. Escrow for insurance and taxes
Another common type of escrow is a mortgage escrow account. This type of escrow occurs after the sale of the home and is between the lender and the new homeowner.
If you use a mortgage to buy a home, you may have a mortgage escrow account to help pay for certain insurance and taxes. Lenders require an escrow account as part of the mortgage agreement. This type of escrow account is more long-term, often for the life of your loan. It’s opened and managed by your lender.
Your mortgage servicer or lender will assess the amount of money needed to maintain your mortgage when calculating your monthly mortgage payment. Then, your servicer will deposit this money into the escrow account.
Your mortgage servicer will use this money to pay property taxes and homeowner’s insurance payments. The servicer will make the payments for you. This is done to ensure that those bills won’t be late. This is important since if you’re late on these payments your insurance provider or local government could place a lien against your house, resulting in a policy lapse or unpaid taxes.
When establishing a mortgage escrow account, you typically will prepay some of the escrow at closing. For example, your lender may require that the first year of homeowners insurance is prepaid. After the first year, you’ll start funding the costs as part of your monthly mortgage payments.
The amount of money you’ll pay in the escrow account will depend on your yearly property taxes and homeowner’s insurance. Your lender will conduct an annual escrow analysis to ensure you’re funding the correct amount into your escrow account each year since these expenses can change yearly.
If these expenses had decreased and you paid too much in a particular year, your lender will send you a refund for the surplus.
What Is the Purpose of Escrow?
As mentioned, setting up an escrow deposit during the home buying process protects the buyer and seller. This type of escrow account ensures that if a contract falls through both parties are protected. For instance, if the buyer must withdraw their contract, the seller will keep the escrow deposit. If the contract falls through because of the seller, the buyer will typically get that earnest money back.
After the sale of the home, many homeowners set up a mortgage escrow account. This escrow account ensures that certain taxes and insurance payments are made on time and in full.
Who Manages the Escrow Account?
A third party manages the escrow account. This party can be an escrow company, mortgage servicer, escrow agent, or lawyer.
Escrow account for your earnest money deposit
The escrow deposit can be overseen by a specialized company, like an escrow company or an escrow agent. This third party is sometimes also the title company.
The third party managing the buyer’s escrow deposit may also oversee some of the paperwork during the homebuying process, such as the deed. Since the third party may be working for the seller and buyer, the fee may be split between the buyer and seller.
Ongoing escrow account for insurance and taxes
Your mortgage servicer will help you manage your mortgage from your closing until your loan is completely paid. They will collect your mortgage payments, manage your mortgage escrow account, and maintain the records of your payments.
The servicer may or may not be your lender. Your lender may sell the servicing rights of your loan. When investigating potential mortgages and lenders, you may want to inquire whether they typically service their loans or sell the servicing rights.
Since the mortgage servicer is managing your escrow account, you don’t have to do much. However, if you change insurance policies or providers, you’ll need to update your servicer with the new information.
What Does a Mortgage Escrow Account Cover?
While a mortgage escrow account covers some taxes and insurance, it doesn’t include all potential expenses. For example, the mortgage servicer won’t collect money to pay any HOA fees or utility bills.
Additionally, supplemental tax bills won’t be paid for by your escrow account. You’ll have to pay for these separately since your servicer can’t predict when (or if) you’ll receive one of these one-time tax bills or know how much the bill will be.
Is a Mortgage Escrow Account Always Required?
No, some people can avoid setting up an escrow account for taxes and insurance. Not setting up a mortgage escrow account will make your monthly mortgage payments lower. However, you’ll need to plan and save for your tax and insurance payments yourself. You’ll also be responsible for making the separate payments.
That said, some mortgages require an escrow account unless certain conditions are met. For example, you may have to put down a certain amount of equity or make a down payment of a certain amount before you can waive escrow. In addition, the state you live in may have certain rules that require setting up an escrow account, or it may be required depending on how you occupy the property.
Are There Benefits to an Escrow Account for Insurance and Taxes?
Mortgages can be complex and even confusing. Using a mortgage escrow account can make the process of paying taxes and insurance more convenient.
Using an escrow account for insurance and taxes ensures your property tax and homeowners insurance payments are split into smaller, manageable monthly amounts. You’ll pay these amounts throughout the year instead of paying these expenses in one large sum each year.
Understanding Your Escrow Options Makes the Process of Buying a Home Easier
Homebuyers and sellers benefit from understanding the escrow process. For example, you may need to establish an escrow account when buying a home or for paying taxes and insurance after you’ve purchased the house.
Understanding whether you’ll be required to establish an escrow account can also help you plan your payments and home buying process better. Additionally, this information may also help guide your decision when choosing a mortgage or lender.