What Is Escrow and How Does It Work?

Posted September 14 2014
by PenFed Team
puzzle pieces of  a family, piggy bank, and family in a house

New homebuyers may be confused by the concept of escrow in part because the term can refer to (at least) two different elements of a real estate transaction.

Typically, an escrow account refers to funds held by a neutral party to be distributed when certain conditions are met. Involving a third party means that the person in charge of the money has nothing to lose if the transaction goes one way or another, and thus insures everything is handled fairly.

However, it adds an extra layer of complexity to a real estate transaction; which may well leave first-time homebuyers a little lost. If you’re not sure how that comes into play in your home hunt, that’s okay. We’ll break down exactly what escrow is and what it means for your home purchase.

Putting Earnest Money in an Escrow Account When Buying a Home

The first time you’re likely to run into the concept of escrow is when you make an offer on a home. You’ll be asked to put down a certain amount of earnest money (think of it as a deposit) to tell the seller you’re serious about buying.

This money is typically held in an escrow account by the title company or real estate broker, though who holds it varies depending on state law (it will, however, always be in the hands of a third party).

The money remains in escrow while the purchase is negotiated to completion, and closes when certain conditions have been met. Additionally, the earnest money the buyer deposits can also go towards the down payment or other closing costs.

The conditions involved in escrow can vary depending on what both the buyer and seller want. These conditions can be as simple as closing when the title is transferred to the buyer, but may also include things like:

  • The house passing an inspection.
  • The seller making specified repairs.
  • The seller being able to stay in the house for a certain period of time (perhaps after closing).

When the conditions are met, your escrow closes. You should expect to have a specific appointment with your escrow officer where both buyer and seller will have to sign paperwork (again, the specific requirements vary from state to state).

At this point, the title is transferred to the buyer and the sale price of the home is transferred to the seller.

If the conditions are not met, and the deal falls through, the money goes back to the buyer—usually minus a small cancellation fee.

Funding an Escrow Account with Your Mortgage Payments

Once the buyer and seller have come to an agreement on the purchase of the home, you’ll probably hear your mortgage lender talking about escrow—which is similar, but different, from the escrow account you opened while negotiating the purchase.

In this case, you make escrow payments as part of your mortgage payment (though you may need to put a large initial payment towards escrow immediately after your purchase).

This extra money goes into an escrow account in order to pay property taxes and homeowner’s insurance. This kind of escrow is often required by your financial institution to be sure the property they’re lending you money for is taken care of.

Having escrow bundled into your mortgage makes it easy to budget for taxes and insurance, because you’re paying a bit every month. How much you pay depends on the cost of taxes and insurance, and it can vary from month to month, and year to year, as costs go up or down. However, your mortgage payment might fluctuate over time as a  result of these external expense adjustments—especially if your costs rise unexpectedly (for example, if your home appraisal has gone up significantly).

While escrow definitely makes it more convenient to pay for taxes and insurance, it’s not always the smartest financial move. Money you’ve put in escrow is out of your reach and doesn’t earn any interest. Your lender will probably maintain a cushion of extra cash in order to ensure there’s always enough to meet expenses, so you could certainly be doing more with your money.

If you’d rather opt out of an escrow account, you’ll have to negotiate it with your lender. You may be required to put down a larger down payment, or meet other conditions. Most lenders will want at least 20% down (80% LTV), and will additionally charge a 0.25% Loan-Level Price Adjustment (LLPA) to waive escrows.