Be Informed: What is Escrow?

The first time you heard the term, "escrow" you may have been thrown for a loop. While the word may have had you confused the first time, here are some essential things to know about escrow: What it is, what it's used for, and how it works. 

So What Is Escrow?

Simply put, escrow is defined as a type of legal concept that protects parties in financial transactions (such as buying a house) by holding money or an object on behalf of the parties, until a predetermined condition has been met. For example, if you have a mortgage on your house, part of your monthly payment may be kept in escrow to pay property taxes when they are due (more on this later).

An escrow company provides two parties the service to make sure everyone does what they say they're going to do. The escrow company acts as a middleman to protect the assets while the home purchasing process is happening.  

Applied to real estate transactions - when buying or selling a home, escrow is the trusted third-party, who is someone other than the buyer or seller, who will hold money to make sure you execute the transaction correctly.

The key thing to remember here is that the third-party is a trusted party. This is a neutral entity that doesn't care whether a home buyer or home seller comes out ahead of the other. The primary role of an escrow service is to make sure each party in a real estate transaction holds up its end of the deal. 

Search for a reputable escrow company, or ask your real estate agent for a recommendation to find a trustworthy service.

How Escrow Works When Purchasing A Home

When buying a new home, you agree to pay the purchase amount within a certain time, and the seller will provide the home they're selling. Your home purchase is probably contingent on a few things; namely financing and a home inspection. While you're securing financing and scheduling a professional home inspection, you might make an escrow payment, or an "earnest money," writing a check to the escrow provider in an agreed-upon amount that shows your intent or seriousness of purchasing that home. This gives the seller some reassurance that you're serious.

Escrow opens when a buyer and seller sign an agreement for a real estate transaction, then deliver the agreement to an escrow officer who helps make sure everyone meets the contract conditions. 

Escrow closes when everyone did everything they agreed to do, and the homeownership is transferred to the buyer.

Once the escrow provider verifies everyone held up their end of the agreement, they'll either give you a refund, apply it to the purchase price or the home, or pass the money along to the seller (if the buyer doesn't satisfy requirements). 

Escrow Accounts For Homeowners Insurance And Property Taxes

The other time you'll hear about escrow may be for an escrow account, which is slightly different than for a real estate transaction. When making your monthly mortgage payments on your home loan, you may also be paying for additional home expenses like property taxes and homeowner's insurance as part of one lump sum.

Property taxes are usually an annual expense, and sometimes homeowner's insurance is as well, though many insurance companies accept monthly payments. To alleviate the lender's risk of you not budgeting properly for these payments, they make sure tax and insurance get paid by adding them to your monthly mortgage payment. 

This portion of your monthly payment is deposited into a separate, escrow account. These funds are kept in escrow (by a company outside of both you and your lender) until their respective payments are due once a year, then they'll make the payment on your behalf. You'll discuss this with your lender when you finalize the purchase of your home, so it shouldn't be a surprise. 

If there's a difference in how much you owe and how much you've contributed to the escrow account, your lender will let you know. You'll either receive a refund if you overpaid, or if you didn't contribute enough, your lender will pay the difference, then send you a bill for the additional amount. You may be able to pay the bill over the coming year.