‘In Escrow’ Meaning: Real Estate Jargon Broken Down
Let’s say you’re in the middle of the homebuying process. You and the seller have agreed to several contingencies in your purchase agreement and made a good faith earnest money deposit. Where does that money go? You’re not giving it straight to the seller. What if they spend it, and then your deal falls through? Then you’d be out tens of thousands of dollars and no closer to buying a home.
Escrow accounts prevent this from happening.
Let’s explore what in escrow means, how it works, and the pros and cons of having an escrow account.
‘In Escrow’ Meaning
When you’re in the middle of a real estate transaction, the buyers and sellers must meet the obligations in the home purchase agreement before a home and funds can officially trade hands. During this time, these items are “in escrow,” meaning that a neutral third party (a.k.a. the escrow agent, escrow officer, or escrow company) holds and manages the assets until the transaction conditions are met. An escrow agreement defines these terms, conditions, and responsibilities. Once the terms are satisfied, the escrow agent releases everything held in escrow to the appropriate recipients.
In other words, when funds for a real estate transaction or taxes and insurance are in escrow, the buyer and the seller can only access them once the deal is completed or falls through.
How Does Escrow Work?
In real estate, there are two types of escrow accounts because of the purposes they serve. Here’s how each escrow process works.
Escrow for Home Buyers
First, escrow protects a buyer’s earnest money deposit until the terms and conditions are met. As anyone who’s ever been involved in a real estate transaction can tell you, there are plenty of things that can delay or cause a contract to fall through. If the buyer is at fault for the contract falling through, the seller typically gets to keep the earnest money as compensation for the delays they face when selling their home. The prospective buyer gets their earnest money back if the seller is at fault.
Though there are many, here are some of the most common situations when a real estate contract may fall through. Who is at fault for many of these scenarios depends on what contingencies are in place:
- Financing: This contingency means the buyer needs to obtain financing or a home loan from a mortgage lender in order to buy the home.
- Insurance: This contingency means the buyer needs to secure the necessary insurance for the home.
- Appraisal gaps: This contingency says that if the appraisal value of the home is less than the agreed-upon purchase price, the seller is at fault.
- Home inspections: If there’s a home inspection contingency in place, the buyer can request a home inspection and then require the seller to make specific repairs outlined in the home inspection report.
- Title search: Lenders usually require a title company to conduct a title search to determine the home’s ownership and if there are any liens. Title search contingencies say that if the title is not clear, the transaction can’t be completed.
The new home owner’s earnest money deposit is applied to their down payment if the transaction goes through.
In some cases, escrow may be held after the sale has gone through, for example, if the new homeowner agrees to let the seller stay in the home beyond their planned move-out date or if issues with the house are found during a final walkthrough. When this happens, escrow is held back until any final conditions are met.
Escrow fees are usually 1% to 2% of the total real estate transaction and are included in your closing costs.
Mortgage Escrow Accounts
Unlike your homebuying escrow account, mortgage escrow accounts are used throughout the duration of your loan. Once you purchase your new home, your mortgage lender will open an escrow account to pay your homeowners insurance and property taxes. They then place a portion of your monthly mortgage payment into this account until these payments are due.
This is because, unlike your mortgage payment, homeowners insurance and property taxes aren’t due every month. Homeowners insurance is due once a year, while property taxes are due every six months. Also, unlike your mortgage payment, your insurance and property taxes vary yearly based on the cost of premiums and changes in your tax bill.
Each year, your lender or escrow service will look at your monthly escrow payments to ensure you’re not paying too much or too little and make adjustments as they go. If they find you’ve been paying too much, you’ll receive an escrow refund. If you’re paying too little, you can make a lump sum payment to cover the difference or agree to increase your monthly mortgage payment.
What Don’t Escrow Accounts Cover?
Escrow accounts specifically cover earnest money, homeowners insurance, and property taxes. They don't include other tax bills, HOA fees, or any other bills, such as water/sewer/gas, cable, and internet.
Pros and Cons of Escrow Accounts
The benefits of escrow accounts far outweigh their drawbacks. However, you should be aware of both their pros and their cons.
Pro: Earnest Money Deposit Protection
By putting your earnest money in escrow, you safeguard it if your transaction falls through. It can be released to the seller if the buyer fails to meet their contractual obligations or returned to the buyer if the seller is at fault.
Pro: Tax and Insurance Payments
Once you achieve homeownership, having an escrow account lets you include your insurance and property tax payments as part of your monthly mortgage payment. Without one, you’ll be responsible for coming up with a year’s worth of homeowners insurance payments every 12 months and six months' worth of property taxes twice a year. Saving for these bills then becomes your responsibility.
Pro: No Late Payments
As long as you make your monthly mortgage payments, your lender or escrow servicer will ensure that homeowners’ insurance and property taxes are always paid on time. You won’t have to worry about incurring any late fees.
Con: Higher Mortgage Payments
Since your escrow account has you paying for homeowners insurance and property taxes each month, your monthly mortgage payments will be higher. However, you’ll still be required to pay these bills in full when they come due.
Con: You Could Be Underpaying
If your home’s value drastically increases or your municipality raises property taxes, you’ll likely be required to pay more than you already are. The same goes for homeowners insurance premiums. However, as with your higher mortgage payments, you’ll still be required to pay these bills — you’ll just pay them in bulk rather than over the course of the year.
Should You Get an Escrow Account?
Now that you know what having something in escrow means, should you opt not to have this account?
Escrow accounts makes sense unless:
- You feel like taking unnecessary risks during the homebuying process
- You want to be responsible for paying extra bills that you could otherwise automate
Find Your Dream Home With Aalto
Understanding what in escrow means, why you need an account, and how it can help you feel like a lot of information to take in. It’s meant to be — because the traditional real estate process is daunting by design.
At Aalto, we’re here to help. We’re a self-service real estate platform dedicated to shifting the balance of power in residential real estate away from industry insiders and toward consumers. We handle all legal documents and negotiations and are here to make buying or selling your home a smoother, less stressful experience.
Are you ready to take control of your real estate transaction? Get started today!