What is escrow and why it is needed?

There are plenty of unique terms that deal with the application process and mortgage loans. You've probably heard of the term escrow a time or two, especially when discussing your mortgage loan with your lender. While it's a fairly common word in today's business world, not many people know exactly what it means, what it covers and why it's needed. If you're one of these consumers who happens to be totally in the dark, here is almost everything you need to know about escrow and what it means for you as a new homeowner.

What Is Escrow?

The best way to define escrow is the process of giving a neutral third party something of great value until the specific conditions of the contract are met by both parties. This is done in order to protect the buyer, the seller and the lender while the transaction is in progress. The material of value usually pertains to a deposit of funds known as an earnest money check, a deed or the sales agreement. Once everyone is paid and the deed is recorded with the county, the escrow will then close and be finished with.

 Who Handles The Escrow?

The most important factor of escrow that it is handled by an impartial third party who has nothing to gain nor lose from the transaction. Depending on the specific laws in the state you live in, that third party could be anyone from a qualified escrow agent, to a title agent or even a closing attorney who specializes in real estate. There are also many reputable escrow or title companies who do nothing other than handle paperwork for a sale and notify each party of what needs to be done. At the close of the escrow, the seller will then receive their funds from the buyer or their lender and the ownership of the home is then transferred to the buyer.

 How Long Is An Escrow?

The length of an escrow really depends on the terms set forth in the purchase agreement and can typically range from just a few days to several months. To give you a good idea of just how long it can take, the average amount of time it takes to close an escrow for a home purchase is about 40 days. The process can take longer depending on how much paperwork is involved as it can take the escrow agent awhile to review it all. Before the real estate market bubble in 2008, escrow took about 30 days, but lenders are now taking extra time to review appraisals and other documents. This is why an escrow now takes a little longer to close.

 How Much Does Escrow Cost?

There usually isn't an upfront fee associated with escrow because most escrow agents take a small percentage of the cost of the home. This percentage will likely range from 1%-2% but can be more depending on where the property is located or other special circumstances. The broker usually recommends an escrow holder, but it's important to note that in order to protect everyone involved in the transaction, there are laws that prohibit escrow services from charging a referral fee.

Escrow Accounts

Besides having an escrow between the buyer and the seller, most lenders will proceed with a second type of escrow known as an escrow account. These accounts are designed to let the lender collect property taxes and insurance from the buyer each month along with their principal and interest. This is of course to protect the lender in case the buyer doesn't cover the home with insurance or pay the property taxes. Some lenders require escrow accounts and some don't, so it's best to find out the specifications before you agree to the mortgage loan. Also keep in mind that an escrow account will likely be required on all high-risk loans such as those with only a 20% down payment. This is because you have less equity in the property and the lender wants to protect themselves.

The way escrow accounts work is pretty simple. At the end of each year, the lender will adjust the buyer's monthly escrow amount based on the actual tax and insurance bills. If the payments come up short, the buyer will generally absorb the remainder by spreading the difference out over the next 12 months. If the buyer paid an excess amount of funds, they will then be refunded by the lender.

 Hold-Back Funds

While most escrows close with no problems once the terms of the agreement have been met, there are certain circumstances that may lead to the funds being held after the home ownership transfers to the buyer. For example, if the buyer is letting the seller and their family stay in the house for a week or so after closing. If this is the case, the escrow agent may hold back a portion of the seller's proceeds until they have fully moved out in order to pay the buyer according to a “rent back” agreement established in the contract. Another instance where a hold-back may take place is if there was a problem discovered on the final walk through of the home and the seller agreed to make the repair but it couldn't be completed before the time of closing. The escrow agent will then hold-back enough funds to cover the cost of the repair just in case.

 Why Do I Need An Escrow?

Whether you're a buyer, seller, lender or borrower, you undoubtedly want to protect yourself with escrow during the home buying or selling process. This is because you of course want to ensure all of the instructions in the contract have been followed by all parties before the money or deed is transferred. The escrow agent will safeguard all of the funds and important documents until all provisions of the agreement have been fully met and then properly distribute them at closing.

Escrow isn't just used during the home buying or selling process. It's also fairly commonly used for the transfer of other high quality properties such as websites, cars and businesses. Hopefully you now have a better understanding of what escrow is and why it's so important for buyers, sellers and lenders.