You have probably heard the word “escrow” used in different financial situations, but what does it mean? How does it work? How is it beneficial for a homeowner, seller or buyer?
What is Escrow?
Escrow is simply a legal agreement where money is held by a third party until agreed upon conditions have been met.
What is an Escrow Account?
We will address 2 types of escrow accounts typically used in real estate. One is used for the homebuying process and the other is used across the life of your mortgage loan.
Escrow for Home Buying
After your offer is accepted by the home sellers, the purchase agreement may require “earnest money.” Earnest money is a good-faith deposit that shows the seller that you are serious about buying the home.
Earnest money is put into a third party escrow account to protect both the buyer and seller until the transaction is complete. If the home purchase is successful, the money will be applied to the buyer’s downpayment.
If the contract is broken before the home sale is complete and the seller is at fault, the buyer gets their money returned to them. If the buyer is at fault, the seller usually gets to keep the deposit.
When you hear people refer to houses being “in escrow,” this is often the scenario they are referring to; there is a buyer interested enough to deposit earnest money.
Escrow for Homeowners
After the purchase of your home, your mortgage lender will likely establish an escrow account from which to pay your property taxes and home insurance. Part of your mortgage payment will include estimated dollar amounts for both your taxes and insurance. The lender will set aside money earmarked for taxes and insurance to pay when the bills are issued.
For example, if your property taxes were $1,200 for the previous year, $100 of your monthly mortgage payment will be set aside for the property tax bill. Escrow will pay your property tax bill from this money when it comes due.
Escrow Pros and Cons
Benefits of Escrow
With an escrow account, you will not have to come up with a lump sum of money when your property taxes or homeowners’ insurance are due. Since you are paying smaller amounts all year long, it is a more manageable feat.
Another convenience of an escrow account is that the escrow agent will pay your tax and insurance bills without you having to manage dates, amounts, etc. The bills will automatically be paid on time every time. They will even cover the difference if your funds are short (more on that later).
Disadvantages of Escrow
Escrow estimates may not be 100% accurate. Escrow agents estimate the cost of your taxes and home insurance based on the previous year. Taxes and insurance costs change regularly. If costs increased for the current year, the funds will be too low to pay the full amount.
If the funds are short, the lender will likely cover for you in order to pay the bill. However, you will have to pay that money back. This would mean that your mortgage payment would increase the next year to cover the new higher costs and allow the lender to be repaid.
On the other hand, if your costs decrease and you have too much money in your escrow fund, you will receive a refund!
Note: escrow accounts do not cover other fees and homeowner costs. They do not collect money to pay HOA fees or utility bills.
Escrow is a common and important part of purchasing a home. It protects buyers and sellers during home sales, as well as provides a convenient way for you to pay for your property taxes and homeowners’ insurance.
Still have questions? Team Rockensock can help! We are more than happy to help answer questions and even refer you to our preferred lenders to get the ball rolling.