Simply put, escrow is a legal measure in which two parties involved in an active 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 keep their ends of the bargain through the course of negotiations. People commonly use the escrow process in the international trade, stock market and real estate arenas.
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 the case of real estate, a lender might require higher-risk borrowers to put mortgage insurance or other mortgage impounds into escrow.
The definition of escrow varies from state to state. In some states, escrow holdings must be non-interest-bearing accounts. In other states, escrow accounts can earn interest. In 15 states, the escrow account holder is required to give any earned interest back to the party that had its assets in escrow. So it will benefit you to do your homework and discover what the laws regarding escrow in your state involve.
Strict rules regulate how financial institutions establish and maintain escrow accounts, in addition to how they prepare statements, conduct analyses and handle funds. Lawyers can also establish client trust — or escrow — accounts. Attorneys are bound by strict rules, one of which is 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. Interest on Lawyer’s Trust Accounts laws, which are on the books in all states, require lawyers to pool any escrow account interest to provide legal services for the underserved.
In all cases, escrow agents must abide by the account’s written instructions.
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How Does Escrow Work?
The way escrow works can be described in four easy steps:
- Two parties engaged in a transaction reach a point at which either one or both 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 neutral third party is often a bank, an attorney, or in the case of real estate, a title company agent or a representative from the closing company.
- The parties agree in writing on the escrow process terms. In its most basic form, this agreement might be that a buyer puts a payment into escrow, which then triggers the seller to ship merchandise. If the buyer receives the merchandise as promised, the escrow agent releases the money to the seller. If not, the escrow agent returns the money to the buyer.
- The escrow agent is paid, the account is closed and the three parties have no further obligation to each other.
How Much Does Escrow Cost?
Escrow fees can vary considerably from state to state, as can rules on whether the buyer, seller or both are responsible for paying them. For real estate transactions, escrow services generally cost between 1 percent and 2 percent of the home’s price. Sometimes, depending on the company, escrow fees can be calculated as $2 per thousand of the purchase price, plus $250.
Typically, the buyer and seller split the escrow-handling fee, but the contract can cover any type of arrangement. For the sale of a business, escrow services usually cost less than 1 percent of the sale price and the buyer and seller split the cost evenly. For very small deals, however, escrow agents might impose a minimum fee.
Escrow and Mortgage Lenders
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, up-front deposits to an escrow account without risk while the details of the sale are still going on. Sellers are protected against buyers walking away from the deal at the last minute without any good reason because if that happens the seller can claim the earnest money the buyer placed in escrow. 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.
Mortgage lenders also use escrow to ensure that buyers pay their taxes and homeowners insurance. Generally, homeowners don’t pay directly into an escrow account, but pay one monthly sum to the lender, which includes the loan’s principal loan, interest, taxes and insurance. The lender keeps the tax and insurance payments in an escrow account to pay for them when the time arrives, saving you from having to budget for those costs. Initial payments often go into escrow as part of closing costs, and you can use an escrow calculator to predict what your required escrow payment will be.
Escrow accounts provide a safe, neutral haven for two negotiating parties to hold assets until they’ve reached an agreement. Escrow accounts come in all shapes and sizes, but the bottom line is that they protect and serve both of the interested parties.