In a world where you can purchase almost anything with a click of your mouse, homebuying can seem very confusing. From words you’ve never heard of to piles of paperwork, it’s natural to feel overwhelmed.
But you’re not alone.
Let’s take a closer look at one of the most common terms you’ll hear in the homebuying process – escrow.
What is Escrow?
Escrow refers to a financial situation in which a third party organization holds money while a contract is finalized. Escrow accounts are also utilized for holding money on another’s behalf for the purposes of paying an obligation (e.g. taxes & insurance).
This legal arrangement can be used in a variety of situations, including landlord-tenant arrangements, and even employment agreements, but escrow is most commonly associated with the homebuying process.
The purpose of using escrow is to protect all parties by keeping your money safe until the conditions for purchase have been met.
What Money Goes Into Escrow?
When buying a home, it’s common for your down payment and, if applicable, your earnest money, to be placed in escrow. Your down payment, and earnest money, sometimes called a “good faith deposit,” serve different – but related – purposes.
Earnest money is intended to compensate the buyer for their time or damages should the potential homebuyer have a change of heart. So, just as the name implies, this funding shows your “good faith” in moving forward.
Once you receive your keys, your earnest money is usually applied toward your down payment and closing costs. There are some ways to have your earnest money returned, such as if the deal falls through. However, until that time, your earnest money will remain in escrow.
While not all home purchases involve earnest money, nearly all home purchases involve a down payment. Though your down payment ultimately goes to the seller, it provides your lender with proof of your financial preparedness and is a consideration in your financing arrangement.
Just like earnest money, there are circumstances under which this money may be returned, should conditions not be met. That said, it will remain protected in escrow until the circumstances are met for its release.
How Do I Open an Escrow Account?
Thankfully, most home buyers do not need to seek out a vendor for their escrow account.
In the case of earnest money, your real estate agent will likely collect that money on your behalf after you have signed a purchase agreement. The name of the escrow company should appear on that agreement, and your real estate agent should be able to answer questions about their services. This earnest money will remain in escrow as the rest of the purchase unfolds.
Your down payment enters escrow a bit later in the process.
For real estate transactions, title companies commonly act as escrow officers.
Often, you will bring a cashier’s check (yes, those still exist!) for your down payment, prior to receiving the title to your home.
Since you may not receive your keys at closing, depending on the arrangement you made with the seller, your money will be safe in the meantime.
Escrow After Buying a Home
Even though the specific escrow account used to buy your home exists only until all arrangements are finalized, escrow will likely be in your life for a long time to come.
After closing, your mortgage lender will usually open a new escrow account for your property taxes and homeowner’s insurance payments. Your lender will then access this account and pay these bills on your behalf.
When figuring your mortgage payments, your loan provider may add extra money to cover these costs, which they place in the escrow account. This account then holds this money to cover those expenses as they arise.
Not every homebuyer chooses this arrangement, but it can minimize stress by ensuring that your property tax and homeowners insurance are always paid on time.
Does Using Escrow Cost Money?
Unlike a typical bank account, which is managed by the user, an escrow account is managed by a third party who is responsible for releasing the money when conditions are met. With that in mind, there is usually a fee for these services. You make your regular monthly mortgage payment and a very small portion of it goes to the servicer of your mortgage. They are compensated, by the holder of your mortgage, for handling your escrow account.
Pros and Cons of Using Escrow
So, what exactly are the pros and cons of an escrow account?
- Proof of commitment – Placing money in escrow can show the buyer and lender that you are 100% ready to make your purchase. This can make the process much smoother for all parties.
- Protection – Scams are everywhere, and life can be unpredictable. With an investment as large as a home purchase, escrow helps you feel confident that your money is protected until you know that the value, home condition, and purchase terms are exactly what you agreed.
- Peace of mind – Using escrow to pay your homeowners insurance and property taxes can provide peace of mind, especially when late payments can have serious consequences, including loss of coverage.
- Serious commitment – You can get your money out of escrow if there are serious issues with the home inspection, the buyer doesn’t close in the expected timeframe, or another possible breach of contract arises. Otherwise, the money placed in escrow is a commitment. Backing out without an accepted reason will result in financial penalties.
- They may be mandatory – If your down payment is less than 20%, lenders may require you to use an escrow account. Most loan programs require that you use escrow.
- If you are financially savvy, you could forgo an escrow account for your taxes/insurance and invest that money. You could earn interest on it rather than the money sitting in an escrow account.
Is My Money in Escrow Really Safe?
The stock market has been a roller coaster, and the economy can impact the real estate market, so you might be wondering if your money is safe in escrow.
Yes, it is.
Escrow accounts are not investment accounts, so market fluctuations do not put you in danger of losing escrowed money. While property tax and homeowner’s insurance may change over the life of the mortgage, requiring an increase in monthly payments, the money held in the escrow account will not change with the stock market.
Furthermore, escrow accounts are not commingled with other accounts held by the title company or the provider, so they cannot be used for purposes other than those intended.
These accounts are also transparently managed with federal law requiring that you receive an annual statement with the transactions in your escrow account. Since escrow accounts are governed by FDIC regulations, they have similar protections in place as those you would find at a banking institution.
With this in mind, you can feel confident that your escrowed money will be used for its intended purpose and will be kept safe from hacking and fraud.
If you still have questions about escrow or anything else about home buying, schedule a free, no-commitment Home Loan Coaching session with our team. We’ll help you understand the home buying process so that you feel confident in your investment.