What is Escrow and How Does Escrow Work?
Buying your first home can be an exhilarating experience: not only are you purchasing your first plot of land, but you’re also completely new to the associated terms and processes. It can be very easy to become overwhelmed or confused, and it’s always important to do your research before making a final decision.
One of the terms that may pop up is “escrow.” But what exactly is escrow, and how does it relate to real estate sales and transactions? Does escrow have other applications, besides buying a home, and what other associated terms are related to escrow?
Let’s dive into the definition of escrow, how the process works, and what this service could mean for your first home purchase.
Table of Contents
What is Escrow?
Essentially, escrow is a way for large transactions to be conducted safely, so both buyer and seller get what they agreed to. Technically, escrow is a financial process defined as a deed, a bond, money, or a property that is held in trust by a third party, which will later be turned over to the purchaser or grantee only after the fulfillment of a contract or agreement. In other words, escrow is the process of handing something over to a third party (someone that is neither the buyer or seller) who can then ensure that all contract agreements are met (buyer pays the agreed price, seller transfers ownership/provides the goods) before the transaction is finalized.
This term is commonly used in real estate transactions, as the third party (escrow) agency may hold onto a property until the seller or buyer meets the demands of the other party. For instance, if a seller promises to repaint the outside of the house before the buyer agrees to purchase the house, then the escrow agency will ensure that the seller stays true to their word. In addition, the escrow agency may also ensure that the buyer pays the seller within the timeframe given.
Whether through selling something large like a plot of land, or whether selling a service such as creating a website for a client, an escrow agency can work as the “referee” between the two teams. They are indifferent to who wins, but they’re there to make sure both teams play fair.
Escrow Process: How It Works
The escrow process is often one of the final steps in a sale. When purchasing a home, the escrow process occurs between the time the seller agrees to the buyer’s purchase offer, and when the buyer gets the keys to their new house. The closing process in real estate is often called “closing escrow” because it is the final step where money and property change hands. For other large transactions, the process will start in a relatively similar way: between when the agreement is finalized and accepted, and before the buyer receives the item.
The escrow agency acts as a third party in the sale, and will collect all the necessary funds and documentation needed to complete the sale. For a home purchase, these items may be the initial earnest deposit money, the signed deed of the home, and the home loan documents from the buyer. Here is how the whole process of escrow will work:
- A Buyer and Seller Will Agree to Terms of Sale: Price negotiations, conditions, financing arrangements, and any other details relevant to the transaction will be drawn up and agreed to by both parties.
- Buyer Opens an Escrow Account and Pays Into Escrow: This is when the escrow agency will collect the earnest money and all the necessary documentation to complete the sale. Escrow companies often act as the third party, but some sales may require a lawyer and these transactions are called “settlements” instead of escrow.
- Buyer Receives Property or Ownership of Goods: Whatever the buyer is purchasing — a home, an investment, or any other high-value goods — is transferred to the buyer. In real estate transactions, that means the title is put in the buyer’s name, and all other legal closing documents are appropriately filled out.
- Seller is Paid From Escrow Account: At this point, the conditions of the transaction have been satisfied: the buyer’s money went into escrow, and property changed hands, so the seller can accept payment. In real estate transactions, it is common for the escrow account to be closed once the initial transaction is settled — closing escrow — only for another escrow account to be opened, allowing homeowners to make PITI payments (Principal, Interest, Taxes, and Insurance on a home) into a single account, which then remits payments to the lender, tax collector, and insurance company respectively.
Escrow accounts work in a very similar way as an escrow agency: they are the middle man between a bank and a loan holder that ensures you stay true to your obligations. Escrow accounts function like any other credit, loan, or online banking account — except with less flexibility on who can receive payments and when those payments are made. Typically, you can view these accounts online through your bank or lender, as the lender is in charge of and manages the account and will manage all the payments.
Mortgage Escrow Accounts
Escrow accounts are commonly used with home purchases because of all the additional expenses that come with home ownership. This includes property tax costs, homeowner’s insurance, and the home loan. An escrow account is normally set up by the lender or bank to ensure that the homeowner makes all the necessary payments into that account. The escrow account acts as a holding tank for that money.
Billing Escrow Accounts
Instead of paying multiple different banks or institutions for all the different expenses, all your monthly payments will be rolled into one, and you will only pay the escrow account. This account (or your lender) will then distribute that money for you to all the necessary recipients at the end of the year.
If you happen to not have enough money to pay the property taxes or other expenses, then the bank may cover the difference for you and have you pay it out over the remainder of the next year. If you overpaid, however, they will reimburse you the difference. Additionally, you can always expect your payments to change year over year, as taxes and other expenses are fluctuating, even if your mortgage rate is not.
Escrow companies and agents are the middlemen of a transaction, but what exactly is an escrow company compared to other financial institutions? Some agents are actually attorneys or notaries, especially in civil law cases. Other escrow companies may be the same as title companies, which is normally the case with home purchases in the United States.
Banks Cannot Serve as Escrow Companies
Either way, the company is a trusted individual or company that both parties agree upon. Banks are not capable of being escrow companies, as they may have a vested interest in getting paid or billing escrow accounts, and an escrow company must remain neutral throughout the process.
If an escrow company is used, they will assign an escrow officer to each transaction. The officer typically receives payment of 1-2% of the cost of the transaction. Both parties are responsible for paying the company or agent, and will agree on the amount paid during the initial signing of an escrow agreement. Additional services, such as title searches, or assistance with closing, may end up costing both parties more money in the end, and the escrow agent will notify you of all the charges that are due to them after closing.
When Are Escrow Services Used?
Besides during home purchases, when else are escrow services used? Some common examples of using escrow include:
- In the high-value transfer of businesses or websites between buyer and seller, or used in the case of mergers between two businesses
- In the completion of remote person-to-person auctions (eBay is a common example of an online escrow company that performs this duty)
- During the purchase of a used car, where money will be released at the end of a warranty period
- Rental deposits, where money will be released or returned after a tenant has vacated the property (and not harmed it during their time living there)
- During construction of a building, where the money will not be released until the service has been completed and meets the demands or expected quality of the buyer
In essence, escrow occurs any time there is a purchase and a third party is used. Strangely enough, vending machines and ATMs are considered “escrows” as they hold onto the money of the customer until the other party (bank or supplier) can come to collect the money. Most commonly, escrow is used in the sale of large items and property — including intellectual property.
Escrow in Real Estate
Escrow is most commonly associated with real estate transactions, as stated above. However, there are other definitions to be aware of in the escrow process of buying a home:
- Close of Escrow: This is the day when the escrow officer finally hands all the money of the buyer over to the seller. In the case of home purchases, the escrow agency may pay off the remainder of the sellers mortgage by transferring the money to their lender. Whatever money is leftover they will then give to the seller. The buyer will also have to go through all the final paperwork, which can be rather extensive. If you can, ask for copies of the paperwork prior to the closing day, so that way you have more time to go over everything without the pressure of time.
- House in Escrow: This is the term used when a home is going through the final processes of being purchased. However, this does not mean a home purchase has been finalized, and there are multiple ways in which the escrow process can fail or fall through. Additionally, home escrow can take up to a month or more before the keys will be handed over, so it can require some time before this process is finalized.
- Failed Escrow: Some examples of failed escrow include:
- If the home is appraised by the bank for less than the selling price, then the bank will refuse to cover the sale price. The buyer will either have to make up the money themselves or forfeit the sale.
- If the escrow company or agent does a poor job, the seller can back out of the escrow process and refuse to sell the home through that agent.
- Is the buyer finds a particularly bad defect when inspecting the home (or some other serious damages), then they may back out of the sale.
- If the lender and buyer have a disagreement or the lender backs out of the loan due to bad credit history or some other issue, then the sale may not occur due to lack of securing the finances needed to complete the sale.
Additionally, escrow can also occur after a home has been purchased. The bank or lender will want to ensure that all payments are made on the home, including property taxes and insurance costs. They can then open an escrow account for the homeowner.
Escrow in the Stock Market
Escrow can also happen in the stock market for publicly-traded companies, which is known as “escrow shares.” These shares may be held in escrow during three different occurrences:
- A business is in the process of merging or another businesses has acquired the other
- When a business has filed for bankruptcy or is being reorganized
- When restricted shares have been granted to an employee of a firm but a vesting period must go by before the employee gains access (such as when companies offer employees “stock options” as a perk for working there, but you have to pass the initial six month probation period.)
Escrow is one of the most essential aspects of purchasing a home, so fully understanding their role in the process is essential. Finding a trusted escrow company can be all the difference in making an educated and worthwhile home purchase.
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Katie McBeth is a researcher and writer out of Boise, ID, with experience in marketing for small businesses and management. Her favorite subject of study is millennials, and she has been featured on Fortune Magazine and the Quiet Revolution. She researches SEO strategies during the day, and freelances at night. You can follow her writing adventures on Instagram or Twitter: @ktmcbeth
This post was updated December 18, 2018. It was originally published November 19, 2018.