Buying a home is one of the most exciting and rewarding experiences in life. But it can also be complex and confusing, especially when it comes to escrow. What is Escrow in Homebuying and how does it work? Why is it important and what are the benefits?

If you have these questions, you are not alone. Many homebuyers are unfamiliar with the concept and process of escrow, which can lead to misunderstandings and frustrations. That’s why we created this comprehensive guide to help you understand everything you need to know about escrow in home buying.

By the end of this guide, you will have a clear and confident understanding of escrow and its role in your home purchase. You will also be able to avoid common mistakes and pitfalls that can delay or derail your closing. And most importantly, you will be able to enjoy your home buying journey with peace of mind and satisfaction.

What is Escrow in Homebuying, and Why is it Important?

Escrow is a legal and financial arrangement that involves an impartial third party, called an escrow agent or company, who holds and manages the exchange of assets between two other parties during a transaction. Escrow is used to ensure that both parties fulfill their obligations and protect their interests before the assets are transferred. Escrow is commonly used in various types of transactions, such as online purchases, business deals, legal disputes, and, of course, real estate.

In real estate, escrow serves as a secure and fair way to facilitate the transfer of property from the seller to the buyer. Escrow involves two main components: an escrow account and an escrow service.

Escrow Accounts for Home Buying

When you make an offer to buy a home, you usually have to put down a good faith deposit, also known as earnest money. This deposit shows the seller that you are serious about buying the home and that you will not back out of the deal without a valid reason. The amount of the deposit varies depending on the market and the contract, but it is typically 1% – 3% of the purchase price.

To protect both the buyer and the seller, the earnest money deposit is placed in an escrow account, where it is held by the escrow agent until the closing of the sale. The escrow agent may be a title company, a bank, an attorney, or another entity that is licensed and regulated by the state.

The escrow account also holds other important documents related to the sale of the home, such as the seller’s deed, the title report, the inspection report, the appraisal report, and the loan documents. The escrow agent ensures that all the documents are in order and that all the contingencies are met before releasing them to the respective parties.

Contingencies are requirements that must be satisfied before the sale can proceed. For example, the buyer may have a contingency that allows them to back out of the deal if the home inspection reveals major defects or if the appraisal comes in lower than the agreed price. The seller may have a contingency that allows them to cancel the sale if they cannot find a new home to move into.

If all the contingencies are met, and the buyer and the seller are ready to close the deal, the escrow agent will prepare a closing statement that summarizes the final costs and fees for both parties. The buyer will have to pay the remaining balance of the purchase price minus the earnest money deposit plus any closing costs and fees. The seller will get the net proceeds of the sale, negative any closing costs and fees, and any existing liens or mortgages on the property.

The escrow agent will then transfer the funds and the documents to the appropriate parties. The buyer will receive the deed, and the keys to the home, and the seller will receive the payment. The escrow agent will also record the deed with the county recorder’s office and notify the lender and the insurance company of the change of ownership.

Escrow Accounts for Taxes and Insurance

After you buy a home, you will have to pay property taxes and homeowners insurance fees on a regular basis. Property taxes are levied by the local government to fund public services and infrastructure. Homeowners insurance is insurance that covers your home and your personal belongings from damage or loss caused by fire, theft, natural disasters, vandalism, and other perils.

It’s possible that your lender and loan type may necessitate the creation of an escrow account to cover the payment of your property taxes and homeowners insurance. Even if it’s not compulsory, you may opt to set up an escrow account yourself for added convenience and peace of mind.

An escrow account is a separate account that is managed by your mortgage servicer. Your mortgage servicer is the company that collects your monthly mortgage payments and handles your loan administration. Your mortgage servicer may be the same as your lender, or it may be a different company that your lender has sold or transferred the servicing rights to.

Every month, your mortgage servicer will collect a portion of your mortgage payment and deposit it into your escrow account. The amount of the escrow payment is based on the estimated annual costs of your property taxes and homeowners insurance divided by 12. Your mortgage servicer will also keep a cushion of extra funds in your escrow account, usually equal to two months of escrow payments, to cover any unexpected increases in your bills.

Escrow Service

An escrow service is the process of overseeing and coordinating the escrow account and the escrow agent. The escrow service is responsible for ensuring that all the steps and requirements of the transaction are completed on time and according to the contract. 

The escrow service also handles the communication and documentation between the buyer, the seller, the lender, the title company, the appraiser, the inspector, and any other parties involved in the transaction. The escrow service acts as a mediator and a facilitator, making sure that everything goes smoothly and efficiently.

The importance of escrow in real estate cannot be overstated. Escrow provides security, transparency, and convenience for both the buyer and the seller, as well as the lender and other stakeholders. Escrow reduces the risk of fraud, miscommunication, and disputes and ensures that the property sale is completed legally and ethically.

How Does Escrow Work?

Escrow works in two main stages: during the home purchase and during the mortgage repayment.

Escrow During The Home Purchase

When a buyer and a seller agree to a purchase contract, they may use an escrow company or an escrow agent to handle the transfer of money and property. The escrow company or agent acts as a neutral third party that holds the buyer’s earnest money deposit, the seller’s deed, and any other documents related to the sale until the closing date.

The escrow company or agent also ensures that all the terms and conditions of the contract are met before releasing the funds and the property to the respective parties. For example, the escrow company or agent may verify that the buyer has obtained a mortgage approval, that the seller has cleared any liens or encumbrances on the property, and that the home inspection and appraisal have been completed satisfactorily.

The escrow company or agent may charge a fee for their services, which is usually split between the buyer and the seller. The fee can vary based on the complexness and the value of the transaction, and it may be negotiable.

The following diagram illustrates the escrow process during the home purchase:

Buyer->>Seller: Agree on purchase contract Seller->>Escrow: Transfer deed and other documents Buyer->>Escrow: Transfer earnest money deposit Escrow->>Buyer: Verify mortgage approval Escrow->>Seller: Verify lien clearance Escrow->>Buyer: Verify home inspection and appraisal Escrow->>Buyer: Release funds to the seller Escrow->>Seller: Release deed and property to the buyer

Escrow During The Mortgage Repayment

After the closing, the lender or servicer may create an escrow account for the borrower to pay property taxes and homeowners insurance. The lender or the servicer will estimate the amount of money needed for the escrow account based on the previous year’s tax and insurance bills and divide it by 12 to get the monthly escrow payment. The monthly escrow payment is then added to the principal and interest payment to get the total monthly mortgage payment.

The lender or the servicer will deposit the monthly escrow payment into the escrow account and use it to pay the tax and insurance bills when they are due. The lender or the servicer will also monitor the escrow account balance and adjust the monthly escrow payment accordingly. If the escrow account has a surplus, the lender or the servicer will refund the excess money to the borrower or apply it to the principal balance. If the escrow account has a shortage, the lender or the servicer will notify the borrower and request an additional payment or increase the monthly escrow payment.

The lender or the servicer is required by law to provide the borrower with an annual escrow statement that shows the activity and the balance of the escrow account. The borrower can review the statement and contact the lender or the servicer if they have any questions or concerns.

The following diagram illustrates the escrow process during the mortgage repayment:

Lender->>Borrower: Estimate escrow payment Borrower->>Lender: Pay monthly mortgage payment Lender->>Escrow: Deposit escrow payment Escrow->>Tax Authority: Pay property taxes Escrow->>Insurance Company: Pay homeowners’ insurance Lender->>Borrower: Provide annual escrow statement Borrower->>Lender: Review escrow statement

Why Escrow Matters When Buying a Home

Escrow is an important part of the home-buying process because it provides security and peace of mind for both buyers and sellers. Escrow ensures that:

• The buyer does not pay the seller until the title is clear and the property is ready to be transferred
• The seller does not transfer the title until the buyer pays the full purchase price
• The funds are handled by a trusted and impartial third party who follows the contract and the law
• The transaction is documented and recorded for legal purposes

Escrow also helps to prevent or resolve any disputes that may arise during the transaction, such as:

• The buyer finding defects or damages in the property after the inspection
• The seller failed to disclose material facts or issues about the property
• The property is appraised for less than the agreed-upon price
• The buyer failing to secure the financing or the approval from the lender
• The seller changing their mind or receiving a better offer from another buyer

In any of these scenarios, the escrow agent can act as a mediator who can hold or release the funds according to the contract and the law. The escrow agent can also refer the matter to arbitration or litigation if the parties cannot reach an agreement.

Pros And Cons Of Escrow

Escrow has both advantages and disadvantages for the buyer, the seller, and the lender. Here are some of the main pros and cons of escrow:

Pros Of Escrow

• Escrow protects the buyer, the seller, and the lender from fraud, default, or breach of contract during the home purchase. The escrow company or agent ensures that all the parties fulfill their obligations and that the money and the property are transferred securely and legally.
• Escrow simplifies the budgeting and the payment of property taxes and homeowners insurance for the borrower. The borrower does not have to worry about saving for large lump-sum payments or missing any deadlines. The lender or the servicer takes care of the escrow account and pays the bills on time.
• Escrow is an effective way to minimize the risk of tax liens or insurance lapses for the lender. This is because the lender has a vested interest in ensuring that the property taxes and insurance are paid on time, which is crucial in protecting the value and the security of the property. Using an escrow account ensures timely bill payments, minimizing losses for the lender.

Cons of Escrow Account

While the advantages of an escrow account are evident, it’s essential to consider potential drawbacks:

• Funding the escrow account through monthly mortgage payments may lead to slightly higher bills. However, this is a nominal trade-off for the convenience of not facing large, sporadic payments for taxes and insurance.
• Fluctuations in property taxes and insurance costs can affect escrow estimates. If your property is reassessed, leading to increased taxes, your escrow might fall short. Conversely, any surplus in the account gets refunded.
• Annual reassessment prompts adjustments to your monthly payment. If short, the payment increases to prevent future shortages; if in excess, it decreases, and you receive a refund.

Conclusion

Escrow is a vital component of the home buying process that safeguards both buyers and sellers from potential risks and problems. By understanding how escrow works and why it matters, you can have a smoother and more successful home purchase experience. 

If you have any questions or concerns about escrow, you can reach out to us today. At Matthew Fischman, we can guide you through the process and answer any queries you may have. Happy home buying!