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

by | Jun 12, 2020 | Finance, Real Estate Glossary

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During a transaction that requires a substantial amount of money, like a real estate purchase, trusting the person on the other side of the deal is essential to the success of a deal being made. 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 comes into play during a large transaction when the two parties involved enlist 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 can 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 escrow provider or escrow agent, preferably recommended by your real estate agent. Additionally, confirm that the escrow provider is licensed in your state.

Escrow providers make the transaction safe because they are protecting the assets of the buyer and also the seller until each party has come through with their obligations within the deal.

How Escrow Works

Real estate transactions can oftentimes be complicated arrangements and 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 also 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 typically 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 a property needs to be conducted before it is sold by the buyer’s mortgage company. Sometimes, issues can arise if the property being appraised is lower than the agreed-upon sale price and banks will not lend money for the amount needed if the asking price is above what comes back on the appraisal report. In this situation, some buyers might want to find the money that makes up the difference between the asking price and the appraised value. If a buyer can’t find the money while this transaction is being held in escrow, then the transaction can be terminated.

Home Inspection 

Buyers can sometimes agree to only purchase a property with the condition that a home passess the home inspection. All of the money for purchasing the property would need to be held in escrow until the inspection is completed 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 searches are performed before the sale of a home in which 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 or no liens on the property which is a requirement for a transaction to go through properly. Funds are held in escrow during the duration of the title search.

Zoning

If a buyer wants to use the property for something that isn’t allowed by the current zoning laws, a seller might allow them to get the zoning laws changed before selling them the property. Items would sit in escrow until the zoning laws were changed and the buyer can now 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.

An escrow provider’s responsibilities in a transaction can 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 escrow provider or escrow agent, preferably recommended by your real estate agent. Additionally, confirm that the escrow provider is licensed in your state.

Escrow and Offers

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

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, a seller could keep your earnest money if an agreement wasn’t made. Additionally, you wouldn’t want to hand over money for the purchase of a property until a deed is signed. Escrow ensures everyone gets what they deserve at the correct time.

Escrow and Lenders

Mortgage lenders also utilize escrow accounts to facilitate funds required to pay bills associated with your mortgage. A mortgage servicer will collect your total payment in monthly mortgage payments and 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 and 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 it helps the homeowner avoid a large annual payment that needs to be paid all at once. If you end up overpaying your taxes, you’ll get a refund to help cover the discrepancy.
  • Private Mortgage Insurance: Private mortgage insurance (also known as 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 (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 will oversee all final paple work, handle the exchange of funds, and also assist with recording of deeds with a title agency. Additionally, this person will ensure 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 because fake one can be set up by someone claiming to sell an item (not just real estate). If the person selling an item becomes suspicious when a different online escrow company is recommended other than the one that is proposed, this might be a good sign that there is an online scam about to take place.

Christopher has been been in the Real Estate industry for 8 years and has had the opportunity to close over 1,000 deals while acting as the Managing Broker for thousands more. Christopher is passionate about continuing to find ways to simplify, maximize, and serve Trelora’s clients exceptionally well and spends his time building teams to deliver high levels of service. When not doing real estate Christopher can be seen training for marathons and ultra relays with his 2 year old daughter, eating pizza, and drinking a steady stream of Diet Coke.

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