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What Is Escrow? Understanding The Process

If you’re buying a home, it’s nearly impossible to avoid hearing someone talk about escrow. This may be a foreign word as it’s not necessarily part of someone's normal banking or money management practices.

However, in the real estate world, this is a common word that gets tossed around in numerous conversations throughout the day!

If you’re wondering, “what is escrow, or, do I need it?” – have no fear. We’ll discuss everything you need to know about escrow below.

So, what is escrow? Simply put, escrow is a legal arrangement where a neutral third party will hold money until a condition, service, or sale has been fulfilled and finalized. The third party is legally obligated to return the money to the appropriate owner if a sale or service wasn’t completed.

Many mortgage applications require the homeowner to have an escrow account. If you’re financing your home via FHA or USDA mortgages, an escrow account is a requirement. If you’re using a conventional mortgage, and putting down at least 20%, escrow may not be a requirement, but it is encouraged.

How Does Escrow Work?

To further understand how escrow works, let’s visit a real life example:

Jack is purchasing a home via an FHA mortgage. As part of the FHA requirement, Jack will need to keep funds in his escrow account. The two expenses that are required to be kept in an escrow account are the property taxes and the homeowners insurance. For the sake of this example, let’s assume Jack’s annual homeowners insurance expense is $1,200 and his property taxes are $6,000 per year. His monthly expense for these bills is $600 ($7,200 / 12).

Depending on the lender, Jack will be required to keep a certain amount of money in the escrow account. Typically this is between 6 and 12 months. Therefore, if the lender is asking for Jack to keep 6 months of expenses in escrow, he would be required to pay $3,600 (50% of annual property tax and homeowners expense) on the day of closing to the escrow fund. If it's the full year, Jack will need to write a check for $7,200.

Jack is essentially prepaying for these expenses. Every month the lender will continue to charge Jack $600 for these bills, where they’ll keep that money in his escrow account for future expenses.

The purposes of an escrow account is to guarantee payment for a responsibility or service to another party. Having your property tax and insurance in an escrow account accomplishes that purpose.

What Does Escrow Mean?

Escrow is when a third party is legally obligated to hold money on behalf of two parties that are in process of completing either a sale or service transaction. Once the sale or service is completed, as agreed upon by the parties, the money is released from escrow and distributed accordingly.

What Is An Escrow Account?

One of the easiest ways to understand an escrow account is to look at it as a savings account that your mortgage lender sets up on your behalf. This account has two purposes; to pay your property taxes and the insurance you have on your home and loan. An escrow account is set up to ensure both the property taxes, and the various insurance expenses, are always paid for.

Your lender will charge you an even amount throughout the year and will deposit that money into an escrow account. At the appropriate time, the lender will distribute these funds to the municipality and insurance company on your behalf.

One of the biggest benefits of an escrow account is the predictability it brings to your finances. Some municipalities ask for the property taxes to be paid either bi-annually or annually. If your property tax expense is $6,000/year, it can easily take you by surprise if you forgot to stash money away for that. When your mortgage company charges you $500 a month for this expense, it is a lot easier to budget and plan for!

What Is Escrow Analysis?

Insurance rates and property taxes change throughout the years. An escrow analysis is when your lender will review the changes in your homeowners insurance, or property tax expense, and update their records/requirements accordingly. Following the same example as above, if the homeowner typically pays $6,000/year in property taxes and $1,200/year in homeowners insurance, the total escrow payments would be $7,200 throughout the year.

If the property taxes increased from $6,000/year to $8,000/year, his lender would forecast a $2,000 deficit in the escrow account. Therefore, to make up for this shortfall, the lender will contact the homeowner and will typically provide two options.

The lender will either allow the homeowner to make up the shortfall in one lump sum ($2,000 for this example) or ask if the homeowner would like to spread their shortage out evenly for the next 12 months. Additionally, the lender will begin charging you for the additional amount each month.

An escrow analysis can go in the other direction as well. Perhaps your property taxes or homeowners insurance is decreasing in the upcoming year. Your lender would forecast an escrow overage and can either keep that money for future escrow expenses or write you a check for the difference.

When Do You Need Escrow?

You’ll typically need an escrow account if you’re putting down less than 20% of the home's value as a down payment. Additionally, specific types of mortgage will require an escrow account. If you finance via an FHA loan, or USDA loan, you’ll be required to keep an escrow account. Conventional loans where the homeowner puts down 20% may not require escrow.

What Is An Escrow Officer?

Now that you have a better understanding of escrow, you may be wondering, what is an escrow officer? An escrow officer is simply the neutral third party who is in charge of managing closing documents, money, and ensuring all parts of the mortgage transactions are done properly. An escrow officer works for both the buyer and the seller, overseeing the entire agreement. An escrow officer will be responsible for the money deposited into an escrow account and will allocate it accordingly once the sale is finalized.

Escrow officers triple check all the numbers and the agreements to make sure they are correct for both the buyer and the seller. They’ll also review the terms of the sale to ensure both parties complied with the other parties requirements.

How Does Escrow Work When Purchasing A Home?

When you purchase a home, escrow works by showing the seller you have the funds needed to close on the home. It will also serve as a savings account to prepay for a specific number of months for your homeowners insurance and property taxes. Your money will be deposited into an escrow account, and will be released to the seller and appropriate parties once you close on the home. This provides an extra level of protection for the seller when they sell their home and has very little downside as the homebuyer.

Now You Understand Escrow 101

Despite how commonly used the word escrow is with the real estate industry, it can also be applied to other industries and businesses as well - such as freelancing. A neutral third party will agree to hold the money and release it upon completion of the work. Therefore, both the buyer and the seller are protected! However, you’re more likely to hear escrow being talked about when you’re looking to buy or sell a home.

An escrow account is needed in real estate transactions whenever you finance your home via an FHA or USDA mortgage. Additionally, escrow will be a requirement on all conventional loans where the down payment does not exceed 20 percent.

Having an escrow account comes with numerous benefits. Many would agree the biggest benefit is the predictability this can bring to your finances.

 

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This page last updated: March 21, 2022