Whether you’re buying or selling, a real estate transaction is a complicated process, filled with things you might not fully understand at first. One word that tends to crop up throughout the process is escrow. But what does it mean, and why is it important? Let’s find out below.
What Does Escrow Mean?
Put simply, escrow is a legally binding arrangement in which a third party takes custody of sums of money, deeds, and documents, until a specified agreement is reached between two parties. In real estate, there are two types of escrow that you’re likely to come across. The first is during the purchase process and is typically referred to as escrow. The second type is normally referred to as an escrow account and is associated with your mortgage.
Escrow During the Purchase Process
Upon arriving at a purchase agreement, the seller and buyer are generally required to select an escrow service or agent, a neutral third party who will act as a middle-man to keep both parties protected. Here’s how it works.
The Buyer’s Responsibilities
The buyer is required to deposit their ‘earnest money deposit’, a sum of money that typically equates to around 1-3% of the sale price. This is paid in good faith to show that the buyer is serious about the transaction and has the funds to proceed, obligating the seller to take the house off the market. Additionally, the buyer will typically be required to deposit a mortgage pre-approval letter as proof that they qualify for an adequate mortgage.
The Seller’s Responsibilities
The seller is required to fulfill their end of the agreement before the funds in escrow are made available to them. This typically involves providing access for a home inspection, making any agreed upon repairs, and completing a title inspection. However, the exact terms and conditions will differ from sale to sale.
Conclusion of Escrow
Eventually, the full down payment will be put into escrow as well as the property deeds. When all agreed-upon conditions are met, the escrow agent will release the deeds to the buyer, and the funds to the seller. If the terms of the sale are not met, the escrow agent returns the relevant funds and documents to the relevant parties.
The Pros and Cons of Escrow
Using an escrow agent during a real estate purchase comes with many benefits for both the seller and the buyer.
- For buyers, escrow is the best way to protect your earnest money and down payment. It removes the risk of the seller taking your deposit and running in case the sale falls through, and minimizes the chance of scams.
- For sellers, escrow ensures that the buyer has the funds and credit to go ahead with the transaction.
- Escrow protects both parties and ensures that all terms of the contract are fulfilled before the transaction can be completed.
- Escrow agents can also take responsibility for distributing fees to other parties besides the buyer and seller, including estate agents, inspectors, lenders, and even the escrow agents own fee.
The only real disadvantage of using an escrow service is that it’s an additional cost, which normally equates to 1-2% of the sale price. However, the fee is typically split between the buyer and the seller, and the peace of mind that it buys is invaluable.
Mortgage Escrow Accounts
The second type of escrow account you’re likely to come across is typically set up by the lender that provides your mortgage. It’s used to store up money that will later be used to pay the annual property tax and home insurance payments. Each time you make a mortgage payment, a portion of the funds will be stored in the escrow account and at the end of the year, the funds will be used to make the tax and insurance payments.
The Pros and Cons of a Mortgage Escrow Account
The advantages of having an escrow account include:
- You don’t have to worry about missing important tax and insurance payments as the escrow service will take care of this for you.
- You don’t have to pay a large lump sum at the end of the year.
- Lenders are protected; if you miss insurance payments and aren’t covered when disaster strikes, it’s likely you’ll have to foreclose, leaving the lender with a potentially damaged home with liens on it.
The disadvantages are:
- Higher mortgage payments.
- In case of incorrect estimates, you’ll have to make up the difference in an unexpected lump sum. This can be common in the first few years as property taxes adjust.
- As estimates change, your mortgage payments will fluctuate year-on-year, making it harder to plan ahead.
For more information, check out our guide to why escrow accounts in a mortgage are so important!