Escrow is a legal process in which parties involved in a transaction appoint a neutral third party to take temporary custody of money, securities or other tradable assets. An escrow agreement reduces risk and ensures both parties meet the conditions of their arrangement. People use the escrow process in the international trade, stock market and, most commonly, real estate arenas. Prospective homeowners go through the escrow process when they close on the sale of a home.
What Is an Escrow Account?
An escrow account, also known as an impound account, is a holding area for assets that can be traded, such as money or stocks. In real estate, an escrow account is typically used during the purchase process as well as after the transaction, when the “home escrow” or “mortgage escrow” is handled by the buyer’s mortgage company.
The standard escrow definition varies from state to state. Strict rules regulate how financial institutions such as banks and title insurance companies establish and maintain escrow accounts, how they prepare statements, conduct analyses and handle funds in escrow. In some states, lawyers can establish client trust — or escrow — accounts. Attorneys are also bound by strict rules, including that they can never mingle escrow funds with the law firm’s money. They must place the funds in a dedicated bank account that is separate and exclusive. State regulations also pertain to the accrual and/or disbursement of interest accrued in escrow accounts.
How Does Escrow Work?
During the homebuying process, the escrow process unfolds in four major steps:
- Two parties engaged in a transaction reach a point at which the process can move forward only if each is certain that the other will be able to fulfill his end of the agreement.
- The parties agree on a third party to serve as an escrow officer, also called an escrow agent. This third party is often from a bank, a law firm, a title company or the closing company. This varies by state.
- The parties agree in writing on the escrow process terms including a closing date, inspection and financing requirements and/or other contingencies.
- Once these conditions have been met, the escrow agent handles the disbursement of all monies, including realtor fees, mortgage payments, title and property insurance, prorated property taxes, recording fees and any liens. The escrow agent is paid according to state and/or mortgage vendor rules, the account is closed and the three parties have no further obligation to each other.
Escrow services are commonly used in real estate transactions to protect the buyer, seller and lender. Buyers can confidently submit earnest money and other required deposits to an escrow account without risk while details of the sale are still pending. Sellers are more protected against buyers walking away from the deal at the last minute because if that happens the seller can claim the earnest money the buyer placed in escrow. The buyer is protected because if the seller fails to properly address an issue raised during the home inspection, the earnest money remains in escrow until the seller satisfies the agreement.
How Much Does Escrow Cost?
As with all closing costs, escrow fees can vary considerably by state, as can rules on whether the buyer, seller or both are responsible for paying them. For real estate purchase transactions, escrow services generally cost between 1 percent and 2 percent of the home price.
Escrow and Mortgage Lenders
Mortgage lenders also use escrow accounts to ensure buyers pay their property taxes and homeowners insurance. Generally, homeowners pay one monthly sum to the lender, which includes a portion of the loan’s principal, interest, property taxes and insurance. The lender keeps the tax and insurance payments in an escrow account and disburses them to the respective companies at the proper time, saving the buyer from having to do this.
The mortgage company adjusts the escrow amounts as property taxes and insurance costs change. An annual statement is sent to the homeowner regarding payments and disbursements made over the last 12 months and the schedule for the upcoming year. After the mortgage is paid off, the homeowner is responsible for making these payments independently.
Escrow accounts provide a safe way for two parties to hold assets needed for a transaction. Escrow accounts come in various types, but they protect the parties involved.