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What Is Escrow in Real Estate?

by Point2 Editorial Staff
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8 min. read

Whether you’re purchasing or selling a home, you’ll likely come across the term “escrow” sooner or later. If you’re not sure what it means exactly, you’re not alone. Plus, with two similar yet different types of escrow, real estate terms like this aren’t always immediately apparent.

So, let’s look at what escrow means when it comes to real estate, for a buyer, seller and regular homeowner.

What Does Escrow Mean?

In its most basic form, escrow means putting money, deeds, documents or other assets into a third-party holding account. These items will stay in this account until an agreed set of conditions and obligations have been fulfilled by the parties involved. After that, the goods will be transferred to the final beneficiaries.

Escrow accounts are designed to prevent fraud and scams and are particularly prevalent in high-value transactions, such as real estate.

Escrow vs. Mortgage Escrow Account

Before we look at how escrow works, it’s worth discussing the two types of escrow you’re most likely to come across in real estate.

The first is simply known as escrow and is used during the purchase process. Both the buyer and the seller will put things into escrow — typically, funds from the buyer, and deeds and other documents from the seller.

The second type of escrow in real estate is a mortgage escrow account. It’s used by homeowners who have taken out a mortgage and their lenders.

escrow agreement doc

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How Does Escrow Work in a Real Estate Transaction?

Buying or selling a home is one of the most complicated and expensive transactions that many of us will ever undertake. Fortunately, escrow offers peace of mind and reduces the risks for both the seller and the buyer. Generally speaking, the most common assets that are placed into escrow during the sale of real estate are:

  • Earnest money deposit
  • Down payment
  • Finance approval letter
  • Property deeds
  • Home inspection report
  • Title checks

Compared to sending funds to the seller directly, this is a far safer way for the buyer to send the large sums of money required when making an offer on a home since there’s no danger of the seller running away with the cash. Likewise, the seller can be sure that the buyer is serious about purchasing the property before they take their home off the market.

The funds, assets and documents will then be kept in escrow until all the purchase agreement conditions have been met.

Typical Escrow Timeline

1.      The Opening of Escrow

Once the seller has accepted the buyer’s offer, both parties must sign a purchase agreement. This will list all conditions that need to be met before the sale can be concluded. With help from their real estate agents, the seller and the buyer must then agree on a trustworthy escrow service to use.

An escrow account is usually opened when the buyer places their earnest money deposit into it. Once the transfer is complete, the seller is generally required to take their home off the market.

2.      Seller and Buyer Carry Out Their Obligations

This stage will differ depending on the contingencies set out in the purchase agreement. However, after paying the earnest money deposit, some of the most common buyer responsibilities are:

  • Send down payment funds to the escrow account
  • Provide proof of financing, such as an approval letter from a lender

Meanwhile, the seller’s responsibilities include:

  • Providing access for a home inspection and putting the report into escrow
  • Make any agreed-upon repairs
  • Place property deeds into escrow
  • Complete a title search on the property

3.      Conclusion of Escrow

Once the escrow agent, the person handling the account, is happy that both parties have fulfilled their obligations, they will release the money to the seller, and the property deeds and any other relevant documents to the buyer. Fees for other third parties, such as solicitors, real estate agents and the escrow service itself, can also be paid directly out of escrow.

If the conditions aren’t met and the sale falls through, the relevant items are returned to the appropriate parties minus the necessary escrow fees.

How Much Does an Escrow Service Cost, and Who Pays?

On average, you can expect to pay between 1% and 2% of the property’s sale price for escrow. This fee is generally included in the closing costs and is usually split equally between the buyer and the seller. However, either party can use this fee to negotiate.

couple signing document

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What Is Escrow on a Mortgage?

Having seen how escrow works when buying or selling a home, you might still be wondering, “what is mortgage escrow, and how does it work?”. As the name suggests, these types of escrow accounts are usually set up by your lender when you take out a mortgage.

What Is Escrow Payment and How Does It Work?

Each time you make a mortgage payment, a small chunk of cash is put into your mortgage escrow account. This is known as an escrow payment. At the end of each year, the funds in this account are used to pay property taxes and your home insurance policy—at least in the U.S. The term is not so common in Canada, where it’s often referred to as a property tax account instead. Unlike in the U.S., only property taxes are paid out of it.

Your escrow payments are automatically added to your mortgage and are estimated by the lender. As such, they can rise and fall from month to month, especially in the first few years. Consequently, your mortgage payments will fluctuate, making it difficult to budget accurately.

Ideally, the escrow balance will be enough to cover the relevant payments at the end of the year. However, if it falls short, you’ll need to provide the extra cash out of your pocket. If there’s more, the excess will be returned to you.

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Do I Need an Escrow Account for My Mortgage?

Whether you need an escrow account for your mortgage is usually determined by your lender. In the U.S., you will typically be required to have one. However, sometimes you can take care of property tax and insurance payments yourself. While this lowers your monthly mortgage payments, you will still be required to pay a lump sum at the end of each year.

With a conventional loan in the U.S., you’ll typically have to have a strong credit profile and pay a significant (at least 20%) down payment to avoid mortgage escrow. FHA loans will always need an escrow account, while VA loans typically require a good credit score and a downpayment of 10%. In Canada, a mortgage escrow account isn’t usually mandatory.

Required or not, there are several clear advantages to using a mortgage escrow account:

  • Never miss an insurance or property tax payment: missing either of these payments regularly can prove catastrophic, with large fines and, in the case of insurance, the lender foreclosing on your home to protect their investment. With mortgage escrow, you never need to worry about this.
  • Spread the costs over the year: Managing one large lump sum at the end of each year can be tricky. Spreading the cost over the year and simply adding it to your mortgage payments is much easier to manage.
  • The lender’s investment is protected: Lenders prefer you to have mortgage escrow. The reason is that if you forget to pay your insurance and your home isn’t covered when disaster strikes, they may be left with a damaged house with liens on it.

For an overview of the real estate market in popular areas across Canada and the U.S., visit the links below:

Homes for sale in Toronto
Homes for sale in Edmonton
Homes for sale in Brampton
Homes for sale in Halifax
Homes for sale in Calgary
Homes for sale in Winnipeg
Homes for sale in Hamilton
Homes for sale in London
Homes for sale in Victoria
Homes for sale in Surrey
Homes for sale in Markham
Homes for sale in Kelowna
Homes for sale in Kitchener
Homes for sale in Saint John
Homes for sale in Moncton

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