What is escrow and how does it work?

Escrow accounts can be used in any situation where money is being funneled from one party to another. It’s most commonly associated with real estate transactions. For example, if the goal is to close on a house in 60 days, an escrow agent will make sure everyone can deliver what they promised by day 60.

Other scenarios for using escrow include legal arrangements, mergers and acquisitions, and banking and internet transactions, to name a few. No one gets paid until everyone is in agreement and the escrow account is closed. In this article, we’ll focus on real estate, since it’s the most popular use of an escrow account.

Buying a home is an exciting time and involves a lot of moving pieces. So having an escrow account set up will ensure that “earnest money,” a good faith deposit made after you sign a contract, will be applied to your down payment. Escrow accounts can also serve as a safeguard for things like property deeds and personal financial records on behalf of the parties after the purchase agreement. Escrow also ensures that scenarios like these are covered:

• The house doesn’t pass inspection.
• The seller wants to change the terms of the offer or back out completely. (Do you get your money back? What if the seller refuses?)
• The process is taking longer than expected.

Funds or assets that typically go into a mortgage escrow account include:

• Homeowner’s insurance
• Property taxes
• The home’s down payment
• Earnest money (a deposit a buyer puts down after signing a contract)
• Closing costs

After closing on your home loan, chances are the lender will set up an escrow account to handle your property taxes and insurance. No need to worry about making a lump sum payment each year to pay these bills. Instead, your regularly scheduled loan payment will include a portion that will be added to your escrow account. The lender then receives your tax and insurance bills and uses the money in your escrow account to pay them when they’re due. This way, your property bills are paid on time, and in full.

Your escrow payment is based on your annual insurance premium and estimated property tax, which gets split into 12 equal amounts, with an added cushion as allowed to help cover any unexpected increase in costs. The monthly amount may change from year to year based on any changes in your insurance premium or taxes.

For those who’ve had their home for a while and are refinancing, a new escrow account will mostly likely be set up, unless you want to pay a lower mortgage and want it to be waived. Of course, you will still have to pay property taxes, insurance and possibly other mortgage costs, but you will be responsible for paying these separately. A fee is often required to waive or cancel the escrow account requirement.

Buying a home is one of the most exciting and important purchases you'll make. Having an escrow account helps give peace of mind to all the parties involved, ensuring everyone gets paid in a timely manner.

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