What Does Escrow Mean and How Does It Work in Real Estate?

During a transaction that requires a substantial amount of money, like a real estate purchase, it’s essential to trust the person on the other side of the deal. The concept of escrow can help minimize risk during these large transactions and allow buyers and sellers to move forward more comfortably and safely. 

Escrow pertains to the two parties involved in a large transaction enlisting a “third party” (escrow provider or escrow company) to temporarily have money, assets, or paperwork held in escrow until the transaction has been completed successfully.

An escrow provider’s responsibilities in a transaction often include receiving assets from one party, delegating funds according to an escrow agreement, and then closing escrow. Since the stakes are so high in a real estate transaction, you should always use a trusted provider or escrow agent. Preferably recommended by your real estate agent. Additionally, it’s important to confirm that the provider is licensed in your state.

Escrow providers make the transaction safe. This is because they protect the assets of the buyer and also the seller until each party meets their obligations within the deal.

How Escrow Works In Real Estate

Real estate transactions are often complicated arrangements. With that, one party in the transaction might be unsure that the other end will hold up their end of the deal. This creates the need for a real estate contract and a neutral third party to mitigate the risk by facilitating the transaction. Essentially, an escrow provider is simply a middle man that ensures the buyer and seller do what they agree to do.

When a person commits to buying or selling an item, such as real estate, certain terms are agreed upon. Below are a few situations where home buyers or home sellers need to enlist escrow services from a company:

Appraisal

Typically, an appraisal of the property is conducted before it is sold by the buyer’s mortgage company. Sometimes, issues arise when the property being appraised is lower than the agreed-upon sale price. Ultimately, when the appraisal price is above the amount on the appraisal report, banks do not lend money for the amount needed. In this situation, some buyers might want to find the money that makes up the difference between the asking price and the appraised value. When a buyer can’t find the money while the transaction is held in escrow, then the transaction is typically terminated.

Home Inspection 

Buyers can sometimes agree to only purchase a property with the condition that a home passess the home inspection. The money for purchasing a property must be held in escrow until the inspection is complete and the property passes. If the conditions are satisfied, the buyer and seller are obligated to fulfill their end of the deal. Thereby releasing all funds from the escrow account.

Financing, Tax and Insurance

A transaction is often held in escrow until the buyer finds the necessary financing or mortgage to complete the transaction. Additionally, a buyer can sometimes have a difficult time securing insurance for a property that is needed for the transaction to go through. If a buyer doesn’t get a mortgage or secure insurance, an escrow officer can null the offer.

Title Search 

Title searches are performed before the sale of a home. This means public records are checked to determine the legal owner of the property. This also helps determine if any liens or claims exist. A clear title means that there are no liens on the property. This is a requirement for a transaction to go through properly. Funds are held during the duration of the title search.

Zoning

Sometimes a buyer wants to use the property for something that isn’t allowed by the current zoning laws. As a result, a seller might allow them to get the zoning laws changed before selling them the property. Items then sit in escrow until the zoning laws are changed. Then, the buyer can use the property for what they intended.

Repairs

Sometimes a buyer includes guarantees that a seller will address repairs on the property. Maybe they wanted a fence removed or part of a building fixed. Funds are typically held in escrow until the seller holds up their end of the deal and makes necessary repairs.

Escrow and Offers

Once an offer is made on a home, a buyer typically writes a check for earnest money. The money is placed in escrow. This means the earnest money doesn’t go directly to the seller. Instead it’s held by an independent third party until the deal is closed. No one can touch the money at this time.

In this situation, escrow is important because it protects both parties in the transaction. If you put down the earnest money and it went directly to the seller, you risk a a seller keeping your earnest money if an agreement isn’t made. Additionally, you wouldn’t want to hand over money for the purchase of a property until a deed is signed. This step ensures everyone gets what they deserve at the correct time.

Escrow and Lenders

Mortgage lenders also utilize these accounts to facilitate funds required to pay bills associated with your mortgage. A mortgage servicer collects your total payment in monthly mortgage payments. Then they pay your bills when they come due, which is usually twice a year. Typically the funds are used to make monthly payments for:

• Homeowners insurance – A person’s homeowners insurance premiums are included in their monthly home loan payment. The portion that is sent to the insurance company is held in a separate escrow account. This is helpful because it’s one less bill that a homeowner has to worry about. It also guarantees that there is always insurance coverage in the event something happens.

• Property taxes – Similar to homeowners insurance, property taxes are also collected and placed into an escrow account. Again, this is helpful because the homeowner is able to avoid a large annual payment. If you end up overpaying your taxes, you’ll get a refund to help cover the discrepancy.

• Private Mortgage Insurance – Private mortgage insurance (PMI) is designed to take away some of the risk for a lender when someone wants to buy a home and puts down a lower down payment. For example, first time homebuyers often utilize this. This money is included in your monthly mortgage payment along with homeowners insurance and property taxes. The money also gets stored in an escrow account before getting divied up to appropriate entities.

Escrow and Closing

When everything is completed, an escrow agent oversees the final paper work. They also handle the exchange of funds, and assist with recording of deeds with a title agency. Additionally, this person ensures all the money is properly disbursed and that the documents are properly signed and recorded. All conditions must be met before closing the escrow account. 

Are Online Escrows Available?

Online escrow services act very similarly to a traditional escrow company. An escrow agency will write up the stipulations of the sale and ask a buyer to upload funds into an account. Once everything is finalized, funds are released. These are useful for all sorts of situations aside from real estate transactions including buying antiques, freelance services, or renting from a landlord. Be careful, as some online escrow companies may not be reputable. When the seller becomes suspicious at a different online escrow company being recommended, this could be a sign that an online scam is about to take place.