Homebuying: How does escrow work?

Buying a home is an exciting time full of possibilities, but also potential pitfalls. After all, you won't necessarily know—and trust—the seller of a property. That's where escrow comes in. It safeguards both parties to make sure everyone is dealing in good faith with some protections put in place.

What is escrow?

Escrow is a process where a third party holds an item, asset, or money during a transaction to protect it until the deal is complete. This ensures that the funds are protected until both parties fulfill their contractual commitments.

While escrow is most commonly linked with real estate transitions, the process can be used in a variety of financial transactions.

How does escrow work when you buy a home?

Escrow is used to protect everyone in the real estate transaction. Up front payments in the home-buying process are held in escrow until the deal closes. Escrow is usually held by a third party, often by a title company or escrow agent.

Scott Royal Smith, Esq. of Royal Legal Solutions in Austin, Texas says, "I always use a title company for that. But you could also have an attorney hold it inside of their trust account if you wanted to."

The escrow agent charges a small fee (usually one or two percent of the transaction) for their services. Often the buyer and seller split the escrow fees, although this can be something that is up for negotiation.

Neither party can access the escrow funds until all the conditions of the sale have been met. Once all the steps in the process have been completed, the money and ownership are transferred.

Eric N, Klein, of Klein Law Group in Boca Raton, Florida, explains that this "protects the buyer in the sense that the escrow agent cannot release the funds until the due diligence has been completed to both parties' satisfaction."

Smith put it this way, "You want to use an escrow account because you can't depend on someone not to rob you. With an escrow company and a contract, you're protected. The escrow company only releases the money when the contractual obligations are fulfilled. This gives you someone who's impartial to make decisions and prevents you from having somebody just run away with your cash."

How much money gets placed into escrow?

During a real estate purchase, you will be asked to put up earnest money, usually one to five percent of the purchase price. This is a deposit on the sale you make once the offer has been accepted. It shows that you actually intend to buy the home and you've got skin in the game.

Earnest money is placed into escrow until the sale closes. The buyer, then, can't retract the funds and the seller can't access them and walk off with them. The money is safe until the sale closes.

Klein says, "Think of a title company as an intermediary. From the seller's side, the title company (escrow agent) collects the keys to the house. From the buyer's side, the title company collects the money. Once the due diligence is completed to the satisfaction of the seller, buyer and lender, the escrow agent releases the funds to the seller and the keys to the buyer and the property is closed."

Why you need escrow

There are many things that can send a real estate transaction off the rails and either delay closing or end the deal. These kinds of issues can arise:

• Problems with the title (legal ownership) turning up during the title search
• A home inspection that reveals major problems requiring repair
• Difficulty getting approved for a mortgage

If the conditions of the sale are not met, the buyer gets the money back. If the buyer, for some reason, changes their mind and defaults on the purchase without a legitimate reason, the seller gets to keep the escrow money.

Escrow and mortgages

The other situation where you may encounter escrow is with your mortgage. When you take out your mortgage, you might choose to have your yearly property taxes and homeowner's insurance paid by your mortgage lender (or the lender might require that you do this). They will make the lump sum yearly payments for taxes and insurance, and you will pay a portion of the costs each month as part of your mortgage payment.

The portion of your monthly payment that goes towards the taxes and insurance is held in escrow by the bank until the payments are due. The funds will sit in an escrow account so they are protected. There are benefits and drawbacks to this kind of escrow.

Benefits of an escrow account

• You don't have to worry about coming up with those huge payments each year. Klein says, "One can feel secure in knowing that the taxes and insurance will be paid and timely."
• You may get a better deal on the mortgage if you agree to escrow.

Drawbacks of an escrow account

• Your money may not earn interest in escrow, whereas it could if you saved it yourself. Smith warns, "When money is being held for you in an escrow account, you have significant dollars tied up that you otherwise should be able to invest and make money from. Once it's out of your control, it's actually costing you more money than strictly your escrow amount because there is a "time cost" to money. You're losing the additional money you could be making through earning interest."
• Your monthly payments might fluctuate as property taxes or insurance premiums go up.

Escrow is all about safekeeping. It protects your earnest money in a sale and allows your mortgage lender to accumulate money to pay taxes and insurance.