If you are purchasing a home or considering purchasing a home, you are likely familiar with the term “escrow” but may not realize what it actually means. Let’s take a look at what escrow is, how it works, and how it can benefit you during your home buying process.
What is escrow?
Escrow is a legal arrangement where a third party temporarily holds money or control of a property until a particular condition is satisfied.
In real estate, escrow is typically used for two reasons: Protecting the buyer’s good faith deposit so the money goes to the right party according to the conditions of the sale, and to hold a homeowner’s funds for property taxes and homeowners insurance.
Because of the different purposes served, there are two types of escrow accounts. One is used during the home buying process, while the other is used throughout the life of your loan.
How does it work?
In the case of the home buying process, escrow is used to protect the funds of what’s known as a “good faith deposit” or “earnest money.” This deposit is there to show that you’re serious about purchasing the home. If the home purchase is successful, this deposit will be applied to your down payment as the buyer, but if the contract falls through due to fault on the buyer’s side, the seller will usually get to keep this down payment.
In order to protect both the buyer and the seller, an escrow account will be set up to hold the deposit. The good faith deposit will sit in the escrow account until the close of the transaction. At that point, the money will then be applied to the down payment.
Sometimes, these funds are held in escrow past the completion of the sale of the home. This is called an escrow holdback. There are many reasons an escrow holdback may be needed such as agreeing that the seller can stay in the home an extra month or finding something wrong with the property during the final walkthrough.
After you’ve completed the purchase of your home, your lender will establish an escrow account to pay for your taxes and insurance. After closing, your mortgage servicer takes a portion of your monthly mortgage payment and holds it in the escrow account until your tax and insurance payments are due.
The amount required for escrow isn’t consistent. Your tax bill and insurance premiums can change from year to year, so your servicer will determine your escrow payments for the next year based on what bills they paid the previous year. Most lenders will require a minimum of 2 months’ worth of extra payments to be held in your account to ensure there’s enough money in escrow.
Your lender or servicer will analyze your escrow account annually to make sure they’re never taking too much or too little. If their analysis of your escrow account determines that they’ve collected too much money for taxes and insurance, you’ll receive what's called an “escrow refund”.
But on the other hand, if their analysis shows they’ve collected too little, you’ll need to cover the difference. You’ll likely be given the option to make a one-time payment or increase the amount of your monthly mortgage payment to make up for the shortage in your escrow account.
What’s the benefit?
The biggest benefit of an escrow account is that you’ll be protected during a real estate transaction. If anything goes wrong during your purchase, you can rest easy knowing that your money is safe with a third-party while things are worked out. It also protects you as a homeowner, ensuring you have the money to pay for property taxes and homeowners insurance when the bills arrive.
Why is escrow important?
Escrow is a necessary part of purchasing a property. It’s there to protect both parties during home sales, and offers an easy way to pay taxes and insurance.
Sometimes an escrow account is required, but other times it's not. This depends on your financial profile and the type of loan you get. While it can be tempting to not utilize an escrow account due to the potential of a lower monthly mortgage payment, an escrow account removes your responsibility to make sure those important bills get paid, giving you peace of mind.
If you feel ready to begin the home buying process, reach out to us! Our team of expert Bay Area agents are happy to help you and match you with the right lender, help you find your dream home, and make your real estate goals a reality.