Escrow: Meaning and How It Works
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When you open a checking account, you trust someone else to handle your money. The same is true of an escrow account in real estate, with one major difference: The account holds both paperwork and funds for you and everyone involved in the transaction. Escrow’s meaning is different depending on whether you’re buying or financing a home, and knowing the ins and outs of each type will help you protect your home investment.
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What is escrow?
In real estate law, the term “escrow” refers to a legal agreement in which a neutral third party handles documents and financial transactions between two or more parties. There are two types of escrow in real estate.
- A purchase escrow, related to buying or selling a home.
- A mortgage escrow, used to pay ongoing housing expenses like property taxes and homeowners insurance.
How does escrow work in a home purchase?
A purchase escrow helps manage all of the moving parts of a home sale. Buyers want to make sure all of the money they put into the purchase is accounted for and they can close on the home without any issues. Sellers are concerned with profiting as much as possible from the sale, and ensuring that they’re released from their ownership stake in the home.
The purpose of a purchase escrow account is to:
- Confirm earnest money was received. Your earnest money is a percentage of the sales price you agree to pay upfront to show the seller you’re serious about buying the house. You agree to this amount in your contract.
- Prepare paperwork to transfer homeownership. This includes legal documents that make you the official homeowner.
- Prepare mortgage paperwork. Your lender requires a signed loan package that records a lien on your house in exchange for lending you money for the purchase.
- Pay all fees related to the contract. This includes escrow disbursements for commissions, lender fees, homeowners association (HOA) fees and any other costs related to your purchase contract.
- Refund your earnest money if you cancel. If an issue comes up with a home inspection or your mortgage application is denied, you can cancel the transaction and the escrow company will return your earnest money.
How does an escrow account work in a mortgage?
Escrow accounts ensure property taxes and homeowners insurance premiums are paid on time, and are required if you make less than a 20% down payment on a conventional loan, and on all government-backed mortgages. The mortgage escrow account’s purpose is to:
- Maintain a balance high enough to pay your bills. The account needs to cover your taxes and homeowners insurance premiums when they are due so you don’t pay out of pocket.
- Notify you of changes in the account balance. When your property tax or insurance bills are paid, the lender must notify you of how much is left, and provide the dates of upcoming disbursements.
- Audit your account every year. You’ll receive a refund if there’s too much money, or have options for how to make up a shortfall.
Lenders collect enough to cover the cost of your taxes and insurance for the next year. They divide that amount by 12 and add it to your monthly mortgage payment. If the numbers are confusing, don’t worry: You’ll get a detailed breakdown of the escrow math on your closing disclosure before signing your final paperwork.
You’re not required to have an escrow account on a conventional loan if you make at least a 20% down payment. You’ll need to ask your lender for an escrow waiver to pay your housing expenses on your own. There may be a small fee if you choose this option, however.
Who manages an escrow account?
The who’s who of escrow varies depending on the type of account. When you buy a home, you generally work with an escrow agent or an escrow company. Escrow agents often work for the same title company that insures the title to your home.
Mortgage escrows are handled by loan servicing companies. Your escrow payments may be made to the same lender who closed your loan, or to a new company. Mortgage servicers are heavily regulated and have to provide accounting statements each year to show how your money is spent.
It’s important to know who to contact if there are issues with your purchase or mortgage escrow. The table below shows who’s responsible for what:
| Contact your escrow agent if: | Contact your mortgage servicer if: |
|---|---|
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Pros and cons of escrow accounts
Pros
Protects your earnest money. Without a purchase escrow account, there’s the risk that a seller could just take your money and run.
Protects you from tax liens. A mortgage escrow account reduces the risk you’ll become delinquent on your property taxes, since the bills are automatically paid.
Eliminates two bills from your to-do list. Your loan servicer is responsible for mortgage escrow paperwork, so you won’t have to keep track of it.
Cons
Someone else controls the money. Getting your earnest money back if a deal falls through may involve extra steps.
Interest isn’t typically earned on mortgage escrow accounts. You may be better off putting your money into short-term deposit accounts. Loan servicers typically aren’t required to pay interest on your funds, unless your state’s laws require it.
Your monthly mortgage payment could change. Property taxes and homeowners insurance premiums usually rise over time, which could increase your monthly PITI payment.
Frequently asked questions
Yes, if the seller agrees to it in the purchase contract. Federal law prohibits a seller from requiring you to use their preferred escrow or title company, but it won’t stop them from rejecting your offer if you insist on choosing a different company.
Yes, as long as there’s no shortage in the account and you’ve made your payments on time. Lenders are required to refund any balance in your escrow account within 20 days of closing on your mortgage refinance.
Yes. An escrow account is mandatory to ensure on-time payment of the mortgage insurance premiums. Mortgage insurance is required on most government and conventional loan programs with less than a 20% down payment.
One drawback to escrow accounts is that in most states you can’t earn any interest on the money in the account. However, the following 15 states mandate that servicers pay you some interest on an escrow account balance: Alaska, California, Connecticut, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New York, Oregon, Rhode Island, Utah, Vermont and Wisconsin.