Get Started
7 min read

What Does Escrow Mean and How Does It Work?

Featured Image

Escrow is one of those terms that you’ve heard countless times without knowing what it actually means. However, knowing and understanding this term is a key component to successfully buying a home. Thankfully, we here at Vaster Capital are well-versed in this area and are here to tell you everything you need to know about escrow.

What Does Escrow Mean?

Generally speaking, escrow is a legal arrangement between two parties that utilizes a middleman that temporarily holds large sums of money until a particular condition has been met. Once the condition has been met, the funds are then officially transferred to the other party.

What Are the Two Different Types of Escrow Accounts?

Part of the reason why escrow is confusing to many people likely stems from the fact that there are two different types of escrow accounts. Oftentimes, people don’t differentiate between them so it can be hard to tell what people are actually talking about when they mention “escrow.” So let’s break down the two different types to provide you with a more complete understanding of this important real estate concept: 

Escrow Accounts for Home Buying

The first type of escrow account is for home buying. When you’re in the process of buying a home, you’re required to put money down as a good faith deposit -- essentially showing the sellers that you’re serious about and invested in this purchase. However, these funds do not go directly to the seller during the closing process.

Instead, they are held within an escrow account. Once all the contract conditions have been met, the funds within the escrow account are transferred to the seller to complete the sale. This is done to protect both the buyer and the seller during the closing process. 

If the sales contract falls through on the part of the buyer, the seller usually gets to keep the earnest money within the escrow account. On the other hand, if the sales contract falls through on the part of the seller, the earnest money within the escrow account is usually returned to the buyer. 

Escrow Accounts for Taxes and Insurance

The second type of escrow account is for taxes and insurance after purchasing a home. In this case, an escrow account helps you save up for expenses like property taxes and homeowners insurance throughout the year rather than having to pay them in a single lump sum. 

The extra amount needed to cover these costs is added to your monthly mortgage payment and placed into an escrow account until the actual payments become due. And while you may assume that your monthly mortgage payments remain constant, this isn’t necessarily the case. 

Insurance premiums and property tax rates may fluctuate from year to year. As a result, your escrow payments may change as well. Your servicer is generally able to determine an accurate rate for each of these expenses but they still may overestimate or underestimate. 

In the event that they overestimate, you are given a refund. In the event that they underestimate, you will be required to cover the difference. For this reason, you’re often required to maintain two months of extra payments within your account for incidentals and minor miscalculations. 

How Does Escrow Work?

The escrow process is anything but straightforward -- so let’s break it down to understand how it really works. 

For starters, the buyer will submit an offer on a home that is then accepted by the seller for the agreed-upon purchase price. After that, the buyer provides an earnest money deposit that is then held onto by the escrow officer. From there, the escrow officer holds onto the money throughout the closing process -- including the inspection, appraisal, title search, etc. 

Once all of the closing requirements have been met, the escrow officer reviews the initial closing disclosure. After review, the final disclosure is issued and the sale can be officially closed. At this point, the money within the escrow account is transferred to the seller. After that, you may set up an ongoing escrow account to manage property tax payments and homeowners insurance premiums. 

Who Manages an Escrow Account?

Depending on what type of escrow account you’re talking about, it may be handled by different parties. If you’re using an escrow account when buying a home, it is usually managed by a specialized escrow company or escrow agent. 

Sometimes your title company may be able to manage your escrow account. Escrow companies may be suggested by the seller’s agent but this is usually up for negotiation -- so don’t feel like you absolutely have to go with their choice if you have a better option in mind. 

If you’re using an escrow account to manage your mortgage payments after buying a home, it is usually managed by your mortgage servicer. This arrangement is extremely convenient and straightforward for you as a borrower. That being said, your lender isn’t necessarily the same entity as your mortgage servicer. Additionally, not all mortgage services offer this.

For this reason, it’s always a good idea to do your due diligence on your lender’s policies and fees. Some lenders service their own loans. Some lenders will sell off the servicing rights to your loan. Some lenders do not offer escrow services directly. Some lenders charge more fees than others to manage your escrow account. These are all things that you need to figure out ahead of time to secure the best possible arrangement. 

Do You Really Need an Escrow Account?

In many cases, escrow accounts are required by your lender. This is especially true if you’re taking out a conventional loan with a down payment of less than 20%. However, escrow accounts usually aren’t required for investment properties

But if having an escrow account is optional as a part of your loan terms, is it really worth your while? After all, these accounts aren’t free. At the end of the day, however, the time, effort, and peace of mind provided by an escrow account is well worth the cost. 

Escrow accounts take a ton of work off your shoulders and allows you to focus on some of the more important and personal aspects of homeownership like buying furniture, doing renovations, etc. It helps you stay on top of property tax and homeowners insurance payments instead of being hit with a large lump sum once a year. 

On the other hand, it is totally possible for you to manage these payments on your own if you’re willing to do the work and stay on top of it.

Pros and Cons of Escrow Accounts to Consider

If you’re still not sure whether or not you should use an escrow account, let’s weigh the pros and cons to help you decide. 

Here are the pros of using an escrow account:

  • Using an escrow account ensures that you’re able to comfortably afford your taxes and insurance since you’re saving towards them throughout the year rather than having to pay a single lump sum. 
  • Using an escrow account essentially pays your bills for you and is able to take quite a few things off your already full plate. 
  • Using an escrow account protects everyone involved in the home buying process -- from the buyer, to the seller, and even the lender. 

Here are the cons of using an escrow account: 

  • Using an escrow account will leave you with a higher monthly mortgage payment. 
  • Using an escrow account may result in changes to your monthly payment as these numbers tend to change over time. 
  • Using an escrow account may result in overpayments or underpayments due to incorrect estimates by your servicer. 
  • Using an escrow account prevents you from investing or otherwise using that money elsewhere. 

How to Successfully Get Through Escrow and Closing

While you may think the work is over once your offer has been accepted, this is really the beginning of what can be a stressful and overwhelming closing process. So how can you get through this process successfully and finally get the keys to your new home? Here are some tips to help guide you through the process: 

  • Do a final walk-through to make sure that everything is in order before closing. 
  • Do not make any big purchases until your loan closes that would affect your borrowing abilities. 
  • Run a title search and purchase title insurance to ensure that the house can be legally sold. 
  • Order a home inspection to make sure that there aren’t any structural or otherwise major issues with the house. 
  • Keep some extra money available to cover a potential appraisal gap.

The Final Rundown on Escrow

Now that you’re an expert on escrow, it’s time to get started on finding the perfect home. The first step in this process usually involves choosing a lender, so feel free to reach out to Vaster Capital for more information regarding your eligibility and qualifications. 

 

Sources:

  1. Understanding the Escrow Process and Requirements | Investopedia
  2. The Pros and Cons of Escrow Accounts | HGTV
  3. 6 Tips to Ensure a Smooth House Closing | Washington Post