What is Escrow and How Does it Work?

When looking at mortgages, you will inevitably encounter a list of unfamiliar phrases. The terms “escrow” and “escrow accounts” are two that will almost certainly appear in several contexts. So, if you want to make informed choices during the mortgage application process, a clearer understanding of these concepts will be essential.

This simple guide will help you learn the essentials of the escrow process and how it can influence your mortgage.

What Does Escrow Mean?

So, what is escrow in mortgage agreements? The answer to that depends on whether you are thinking about the term “escrow account” or talking about something being “in escrow.” 

Escrow is a legal arrangement that is usually mandatory for home purchases. It is designed to protect both the buyer and seller. The agreement effectively sees a third party in the transaction, also known as an escrow agent, temporarily hold money “in escrow” until the conditions of the property sale have been completed.

In essence, we could consider it the bridge between “expressing a serious interest” and finalizing a  property sale.

In most cases, an escrow agreement is completed as follows:

• The buyer pays a deposit, also known as “earnest money,” to the escrow agent.
• The seller takes the property off the market to put it “in escrow.”
• Once the purchase agreement is finalized, the escrow agent releases the funds and the property to the appropriate parties.

In essence, an escrow agreement is when two parties use an escrow agent as the middleman or mediator to safely execute a transaction. Because the money stays in escrow until the transaction is closed (the day the seller gets paid and the buyer gains the title to the property), these services may be needed for several weeks. In some cases, it may even take months.

When an agreement reaches the escrow stage, both parties will be responsible for meeting the deal's conditions. The buyer will need proof of a mortgage loan to support the earnest funds. The seller needs to provide access to the property for inspections and complete any renovations that are deemed necessary before the sale can be completed. 

Once both parties have met their respective demands, the escrow holdback ends, and the transaction can be executed.

How Much Do Escrow Services Cost?

Buying your first property is the largest financial purchase that most people will ever make, which is why the security provided by an escrow agent is always worthwhile. However, as with most services you will require during a property purchase, it doesn’t come free.

Escrow fees are negotiable between buyer and seller, meaning you might not need to pay the full bill yourself. In most cases, the escrow fee is somewhere between 1% and 2% of the property value. With median property prices currently at $374,900, a ballpark figure of $4,000 to $8,000 is accurate for most standard homes.

If you are paying the escrow fee (or at least a portion of it), the costs will be added to your closing costs.

It should be noted that the escrow fee is not the same as the money placed in escrow. The funds placed in escrow usually range somewhere between 1% and 3% of the property value.

This deposit shows the seller that you are serious about buying the property and legally forces them to take it off the market, thus allowing you to complete the purchase agreement.

Upon completion, the earnest funds will become a part of your downpayment on the property, meaning that the agent fee is the only extra cost involved. However, if you fail to complete the purchase, the earnest money in escrow may be awarded to the seller for wasting their time and potentially costing them a sale elsewhere.

What About Escrow Accounts?

In addition to the escrow process when buying a property, you will also find that an escrow account is needed throughout the term of your mortgage. When entering the mortgage agreement, your bank or lender will also provide you with a personal or joint escrow account. Its primary function is to hold a homeowner’s funds for insurance and tax purposes.

While property taxes and insurance are due on an annual basis, escrow payments are made monthly to ensure that your account has the funds to cover those items when they are due.

The main downside is that most lenders will require you to keep two months’ worth of funds (sometimes more if you are deemed a risky candidate) in the account at any given time. This is done to prevent vulnerabilities in times of financial hardship.

The benefits of an escrow account extend to both lender and borrower. Some of the key ones are:

• You become less likely to fall behind on the non-mortgage aspects of homeownership.
• The relatively large annual charges become far more manageable through monthly payments.
• Keeping you on track with non-mortgage aspects reduces the lender’s risk of missing out due to bad debt.

An escrow for property taxes and insurances isn’t technically a legal requirement, but many lenders will insist on one, especially for riskier applicants. 

Once the mortgage has started, borrower escrow accounts will be analyzed on an annual basis to ensure that the current payments are enough to cover the forecast premium increases. Conversely, if it is deemed that you have paid too much, you may be due an escrow refund along with reduced payments for the 12 months to follow.

Does a Mortgage Escrow Account Cover All Non-Mortgage Payments?

While the average age of a first-time buyer continues to rise, the thought of handling non-mortgage homeownership costs remains equally daunting. Your mortgage is only one cost associated with the property and the escrow takes care of two of them through taxes and insurance.

However, the escrow account doesn’t cover everything. Some of the additional charges that you may face include, but are not limited to:

• A one-time supplemental tax bill when the property’s ownership changes hands.
• HOA (Homeowner Association) fees, which could be annual or quarterly.
• Ongoing local taxes.

You will also need to account for the various utility bills and ongoing expenses of owning and managing a property. There are many reasons why your escrow won’t cover these, the main one being that lenders can’t forecast how much those costs will be.

In Conclusion

The answer to the question ‘What is escrow?’ requires some additional explaining, even without getting into the various types of escrow accounts that exist. In the simplest of terms, though, an escrow involves two parties turning to a third one to safely execute a purchase, sale, or rental transaction.

There are two types of legal agreements related to home buying that you should be familiar with. The first is where an escrow agent works as the mediator between a buyer and seller to ensure that funds are protected while the purchase/sale agreement is finalized.

The second is where the homeowner makes monthly contributions into an account so that the annual premiums can be paid.

While the seller and the lender will both gain benefits by removing the risks that they could encounter without an escrow, it is often a lengthy and expensive process.