When buying a home, there seems to be endless paperwork, payments, and contracts involved. Both parties – buyer and seller – want to ensure that the transaction is being carried out fairly and to the agreed-upon terms. But with so much going on at one time, how can you be sure that you’re being protected legally and financially?
That’s where escrow comes in. Escrow describes the financial process in which money for a transaction is held by a neutral third party until the terms of the transaction are carried out. When you hear the term “escrow”, it could actually be referring to two things - an escrow agent, which is used during the purchase of a home, or an escrow account, which is used after your home is purchased.
Let's look at an example.
The finance jargon can be confusing, so let’s look at an example of when an escrow agent might be used during the sale of a home.
Lisa and Adam have found their dream home and placed an offer. Lucky for them, it’s been accepted! However, their offer did include a few pretty standard conditions, like passing an inspection.
While they have accepted Lisa and Adam’s offer, the seller wants some reassurance before taking their house off the market for other potential buyers.
Therefore, Lisa and Adam agree to pay $10,000 in earnest money – basically like a deposit on the purchase, saying they will not back out unless their conditions aren’t met. Lisa & Adam deposit their $10,000 of earnest money to be held by an escrow agent.
Upon closing of the house, once the inspection and other sale conditions are met, the escrow agent will process the earnest funds and apply them to the purchase of the home.
If the conditions laid out in their offer are not met, Lisa and Adam can walk away from the contract and the earnest money would be returned to them.
Lisa and Adam can feel confident that they will not lose out on this money for a home if the purchase ultimately falls through due to unmet conditions.
And the seller is satisfied that Lisa and Adam are serious about the purchase, financially able to provide the necessary funds, and won’t back out without losing $10,000 (unless contractual obligations aren’t met by the seller).
In this case, the use of an escrow agent is essentially a safeguard, where the earnest funds are held and applied to the transaction by a neutral third party, ensuring both parties are protected.
Here, earnest money functions similarly to a “deposit” on the purchase of the home, and escrow is where the earnest money is held until the transaction is complete.
While the previous example is used when the offer is made and during the inspection and pre-closing period, you may also utilize an escrow account at the closing of your home purchase.
Other Types of Escrow
When you close on your home, you can open an escrow account to hold the money for your annual property taxes and homeowners’ insurance.
You will make monthly payments, based on the estimated cost of taxes and insurance. These costs are worked into your mortgage payment to your lender. So you won’t have to worry about making several separate payments for these things – you just pay your monthly mortgage payment, and your lender handles the payments for taxes and insurance with funds from your escrow account. Escrow accounts are an option for all homebuyers, and your lender may actually require one if your down payment is below a particular threshold, usually 20%.
Are there cons to an Escrow account?
While the convenience of an escrow account is a huge selling point, there are a few potential drawbacks to consider.
Escrow accounts don’t accrue interest, so money being held there won’t be growing as if it were being held in a typical savings or investment account.
Your lender may also require a cushion of a few months of insurance and taxes upfront, in case those costs increase in the future.
Escrow agents and accounts are valuable safeguards to help protect the buyer, seller, and lender during real estate and mortgage transactions.
By working with a licensed Mortgage Loan Originator, you can determine if escrow is right for you and how the use of escrow will impact your purchase and mortgage payments.
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