Buying a home for the first time requires learning a new and unique vocabulary. For example, escrow is one of those mysterious terms you hear but may never understand until you go through the home-buying process. However, understanding what escrow is and how it works is a crucial component of many homeowners’ mortgages.
Simply put, the escrow process helps protect sellers and buyers during a real estate transaction. However, how escrow operates and how it affects the buyer deserves a thorough examination. Learn what escrow means and how it works for earnest money, taxes, and homeowners insurance during the home-buying process.
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What Is Escrow and How Does It Work?
Escrow is a term used to describe funds that a neutral third party holds until certain conditions are met. It may come into play in various transactions, but it’s most commonly encountered in real estate.
Where Does Escrow Come In During the Home Buying Process?
In real estate, funds are held in escrow when a buyer puts down earnest money to show they’re serious about purchasing the property. In this scenario, “earnest” money implies that it has been paid with a good faith intention to complete the purchase of a home or property.
This money goes into an escrow account that a third party manages, usually the title company, closing attorney, or mortgage lender. Alternatively, the home buyer may utilize a specialized escrow agent or company. Regardless of who manages the account, the sum is added toward the buyer’s down payment once all conditions of the sale have been met.
Funds may also be held in escrow to help cover the ongoing costs of homeowners insurance and property taxes. The mortgage lender holds these funds in an escrow account and releases funds to pay insurance premiums and taxes as needed.
How Does Escrow Work for Homebuyers?
Earnest money is held in a trust account and is typically due when the buyer and seller have agreed on the terms and price of a home and have signed a purchase agreement. Earnest money on a real estate purchase may be about 3% of the purchase price but can vary depending on local market conditions and competition for homes in the area. Keep in mind that earnest money is paid on top of the down payment on the home, typically about 20%.
If the buyer backs out of the deal or does not meet their obligations under the real estate contract, they may forfeit their earnest money as compensation for any losses incurred by the seller. If the transaction is completed according to the terms of the purchase agreement, the earnest money typically goes toward the down payment on the home.
The purchase agreement may contain contingencies, such as inspections and financing, which allow the buyer to get their earnest money back if the deal falls through. For example, if a home inspection shows that the property has a severe problem, such as termite infestation or black mold, the buyer may be able to back out of the transaction and get their earnest money back. Carefully considering any potential contingencies to include in a purchase agreement is crucial. Without them, prospective buyers may find getting their earnest money back challenging.
How Does Escrow Work for Sellers?
Although the earnest money exists to reassure the seller that the prospective buyer is making a serious offer, the seller does not receive the money until the close of the sale unless the buyer forfeits it due to a breach of contract.
During the closing process, sellers do not typically do much other than make the property available for inspections and appraisals and assist if any help is needed with the title search process.
A title search is a background check on a property that may identify potential problems that could halt the transfer of the title to a new owner, such as outstanding debts that show up as liens on the property or concerns about boundary encroachment with neighboring properties.
If the title transfer process raises questions, it’s in the seller’s best interests to provide help when possible. For instance, sellers may have to pay off outstanding debts to clear liens on the property before the sale can be completed.
In general, sellers must fulfill the contract to access any funds held in escrow. If the seller violates the purchase agreement contract, the buyer can back out of the transaction and receive a refund of their earnest money.
How Does Escrow Work for Homeowners?
Once you own your home, an escrow account performs an entirely different function than it does during the home-buying process. The escrow account will hold funds to pay property taxes, private mortgage insurance (PMI) premiums, and homeowners insurance on your behalf when they are due. Escrow accounts help lenders ensure that property taxes are paid on time to help avoid tax liens on the home and that the home is adequately insured to protect its investments.
PMI premiums might be required if you made a down payment of less than 20% on the home. Lenders may require mortgage insurance to help cover the difference between the outstanding balance of the loan and the home’s value if you default, which may be included in your escrow account.
Not all mortgage lenders use escrow accounts to pay homeowners insurance, mortgage insurance, and property taxes. While some government-backed loans, such as Federal Housing Administration (FHA) loans and United States Department of Agriculture (USDA) loans, require an escrow account, others, such as Veterans Administration (VA) loans, do not require homeowners to use an escrow account (though most VA-authorized lenders will).
What Is Held In Escrow?
Multiple types of funds may be held in escrow throughout the home-buying process and beyond, including:
- Earnest money with a signed purchase agreement
- Property taxes
- Home insurance premiums
- Private mortgage insurance premiums
The money held for taxes and insurance in escrow varies according to your annual home insurance premiums and property taxes. It’s common for the amount held in escrow (and your associated monthly payment) to change over time since taxes and insurance may change yearly.
Mortgage lenders that use escrow accounts typically require a monthly payment of 1/12th of the homeowner’s annual property tax bill and homeowners insurance premium. This amount is added to your monthly mortgage payment, allowing you to make a single payment that covers your principal, interest, property taxes, home insurance premiums, and any PMI.
Depending on how your mortgage company handles escrow after closing on the loan, you may also be required to pre-pay one year’s worth of homeowners insurance premiums and property taxes to create a cushion for these critical financial obligations.
Lenders must conduct an annual escrow account audit. If there is a surplus of more than $50 in the account, they are required to return the surplus to you. However, if there is a shortage, the lender can add the amount to your monthly escrow payment for the following year.
What Does Escrow Cover?
An escrow account protects sellers when they receive an offer on their property. Without the requirement for earnest money from the buyer, sellers may not feel as if the buyer is serious about going through the often lengthy process of closing on a home. When the buyer has provided earnest money, they may be less likely to change their mind and back out of the sale.
Lenders use escrow accounts to force homeowners to prioritize paying taxes and insurance premiums. Many mortgage lenders combine principal and interest payments with home insurance and property tax expenses into a single monthly mortgage payment. They may believe that unless they hold funds to pay future tax and insurance bills in a separate account, the homeowner may not be financially able (or willing) to make sizable annual or semi-annual payments toward these necessary expenses.
Are Escrow Accounts Mandatory?
Some lenders allow homebuyers to pay taxes and insurance premiums independently. Whether a lender uses escrow to cover these expenses is up to the individual lender unless they facilitate certain types of loans that require escrow, as noted above. Once you pay your mortgage, you can close your escrow account and pay your taxes and insurance directly.