What Is Escrow: Everything About Escrow Accounts in Real Estate

October 3rd, 2023  / Author: Zachariah Peterson
Essential Guides

For many Americans, buying a home is the biggest and most significant transaction in their life. Others, who often work with large transactions, are very familiar with escrow accounts because using them ensures fair play. However, if you are just looking to buy a property and are hearing all about these accounts, you might wonder: What is escrow?

To make a long story short - escrows are accounts held by an impartial third party. They provide a safe space where two strangers can venture into exchange when there is no reason to be trustworthy. In this article, we will explore the types of escrow accounts in real estate and their purposes.

The Purpose of Escrow Accounts

When dealing with big amounts of money or things of a certain value, there is always a risk of fraud or theft. Even if you sign a contract with someone, there is always a possibility that the other person will take advantage of your trust. That is when escrows come into question.

Escrow holders are the third party in your contract, and exist only until each side fulfilled what was agreed on in the contract, after which they are responsible for the exchange. In the case of real estate, the exchange is usually either that of the property title and the buyer’s money or of the money for the homeowner’s financial obligations.

Escrows protect both parties in case of unexpected changes of plans or any uncertainties and keep the money safe. Once the money enters an escrow account, it is not easy to get it back. Only if the seller decides to back out of the contract or cannot meet the conditions in the contract can the buyer collect their money.

Types of Escrow

An escrow account is a financial transaction where money is placed into an account held by an independent party called an escrow agent. That escrow agent can come from a bank, title company, real estate company, or specialized escrow provider.

If there are problems with the property, it is often easier to resolve those issues while the money is still in escrow. Escrow accounts are typically required for mortgage transactions. Besides buying a house and paying homeowner’s fees - there are real estate situations where it is preferable to use escrows.

Renters’ Escrow

When talking about different types of escrows in real estate, people usually forget renters’ escrows. Renting is a great option for many people because it allows you to live where you want while saving money. However, there is one thing renters must do to protect themselves against unscrupulous landlords: escrow accounts. An escrow account is a bank account set up specifically to collect rent payments.

Landlords usually require escrow accounts to ensure that tenants pay rent on time. If the tenant fails to make timely payments, the landlord can take legal action to recover the unpaid amount. In addition, landlords can use the funds in the escrow account to cover costs such as property taxes or repairs.

That account will protect the renter, as well. If the landlord does not secure a safe living space for the tenants (doesn’t make necessary repairs, there are water or electricity problems) - the tenants can file a lawsuit, and escrow will hold rent money until the situation is resolved.

If you decide to skip out on rent, however, you could face serious consequences. Landlords can file lawsuits to collect the money owed. They can also report you to authorities, which can lead to fines, eviction, and even jail time.

Escrows in Construction

A construction escrow is a special type of escrow account that allows you to deposit funds into it while work on a property is ongoing. You can use this type of escrow account to protect yourself against fraud because no withdrawals are allowed during construction.

The lender deposits money into the escrow account, and once the house is completed, the funds are disbursed to the contractor and/or owner. If the project exceeds the budget, the lender gets reimbursed out of the escrow account.

Homebuying Escrow

A homebuying escrow account is a type of savings account that helps protect both parties involved in a real estate transaction. In most cases, it is a neutral third party that holds the earnest money deposit while the transaction is being completed. Once the deal closes, the buyer pays the seller the full purchase price minus what he paid into escrow.

Once a buyer puts in an offer and the seller accepts it - the buyer opens an escrow account by transferring the earnest money deposit. The two parties get into a sales agreement and the contingency period is in progress.

Earnest money deposit is one small part of the selling price that shows the buyer’s intent to buy. Earnest money is not the same as the down payment, but it is a part of it. Usually, a buyer will transfer around 2% of the full purchase price to an escrow account.

What is a Contingency Period?

The contingency period marks the time between signing a sales contract and actually fulfilling it. An escrow agent follows the whole process and makes sure that everything is happening according to the contract. Contingencies are conditioning clauses in the contract that offer a way out of the sale in case of major issues with the property or financing.

The most often used contingencies are title, inspection, mortgage, and appraisal contingencies. When a seller or a buyer fails to meet the conditions, they can back out of a sale in good faith - no money nor title lost. However, if anyone wants to break the contract - an escrow agent is there to make sure the other party stays protected.

Homeowner’s Escrow

Homeowner’s escrow is often called a mortgage escrow account because most lenders require it when you’re getting a mortgage to fund your purchase. Mortgage escrow accounts are like saving accounts, which allow you to save money each month. They allow you to put aside some money every month to pay off your home loan.

You'll still have to pay regular monthly mortgage payments, but the escrow money goes to another account. Your mortgage servicer will use those funds to cover taxes, insurance, and maintenance costs related to your property. When you're ready to sell, your lender will release the funds back to you.

Homeowners' insurance premium, property taxes, mortgage insurance - those are all costs that are covered in an escrow. Mainly, escrows serve as money collectors for irregular payments - annual or semi-annual.

If you were to save up that money yourself, you might feel tempted to spend it during the year on some unforeseen expenses. Mortgage escrows ensure that this does not happen.

There are many different ways to set up an escrow account. Here are two options:

Set Up An Individual Account

If you want to open an individual escrow account, you'll need to contact your local bank. Most banks offer this option. If you choose this route, make sure you know what happens when you close your account. Will you lose access to the money? Or will the bank keep the money in trust for you?

Open An IRA With Your Bank

You might consider opening an IRA with your bank. This type of account is similar to an individual escrow account. However, it's managed by a financial institution called an IRA Custodian. You'll still need to open an IRA with your bank, but an IRA custodian will manage the account for you.

Escrow Analysis

An escrow analysis is performed once every 12 months. This process helps lenders determine how much money should be saved each month. Simply put, taxes and insurance premiums can change, and escrow analysis ensures that you can follow those changes.

After your escrow holder ends an escrow analysis, they will send you an escrow statement, in which you will get detailed information about the last year’s spending and the potential for next year’s spending. This potential escrow is called estimated escrow - it tells you how much you will pay each month until the next escrow analysis.

How much you pay each month depends on many factors: the size of the property, location, risk of natural disaster, and many more. Escrow analysis can show that there is more money in the account than the last year’s estimation predicted - in that case, you’ll get a refund. On the other hand, there can be a shortage, too - and you need to pay either immediately in full or in 12 installments during the year.

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