What is an Escrow Account and How Does it Work?

Escrow is one of those terms commonly used in real estate that many people may not understand if they’re buying a home for the first time. Escrow is basically a temporary account held by a third party to make sure funds are properly held until certain conditions are met. In real estate transactions like buying a home, escrow can be used at two different times, but will generally be done the same way in both instances.

Reasons for Escrow in Real Estate

Escrow is used to protect funds until they are used and any conditions from either party are satisfied. Buyers will often set up an escrow account with a third party to hold a deposit for buying the home and then receive those funds back once they have closed on the home. They may also set up an escrow account after the closing to help handle taxes and insurance payments for the home.

Using Escrow to Buy a Home

During the home buying process, the buyer will often offer to put down a deposit on the home. This is different from the down payment. The deposit shows the seller that the buyer is serious about the purchase. If the contract is canceled for any reason by the buyer, the seller will generally keep the deposit and start looking for a new buyer. If, however, the purchase goes through, the amount of funds in escrow can be used towards the buyer’s down payment.

When a buyer finds a home they’re interested in and their offer for it is accepted by the seller, the buyer will use a third party to open an escrow account. The deposit money will be placed in this account and held there until closing. The condition that needs to be satisfied for the funds to be released will be the closing. If closing doesn’t happen, the seller receives the funds. If the buyer closes on the home, they’ll receive the funds from a third party. Once the funds are dispersed, the escrow account is closed.

Using Escrow for Tax and Insurance

After the home is purchased, the lender may require an escrow account to be used for tax and insurance payments. Even if this is not required by the lender or if the buyer pays cash for the home, this is still a good idea. The goal of this is simply to make sure there are sufficient funds to cover taxes on the home and insurance payments each year. The condition that needs to be met is the yearly payments for insurance or taxes.

Once the closing is done, the buyer can open an escrow account and start depositing money monthly. Each year, the funds in the account will be used to pay the taxes and insurance for the home. The goal is to keep the escrow account funded to cover the expenses, but not to overfund the account, as that ties up money that could be used elsewhere.

This type of escrow account doesn’t close automatically at the end of the year. It can be used as long as the homeowner would like. If it’s part of the terms of the mortgage, it will generally last as long as the mortgage. If it’s something the homeowner does on their own, it can be used indefinitely as a way to make sure the funds for taxes and insurance are always readily available.

Management of the Escrow Account

Escrow accounts, no matter the type, are not managed by one of the involved parties. Instead, they’re managed by a third party who handles the funds and makes sure conditions are met before funds are dispersed. By having a third-party handle the escrow account, any potential issues are limited. The money will be set aside for the appropriate use and there is no worry about how the funds will be dispersed when it’s time. If the buyer does want to check on the escrow account, they can do so at any time by contacting the manager of the account.

If you’re planning on buying a home soon, you’ve likely heard the real estate agent or others involved in the process talk about escrow. Though the term may be unfamiliar, this is not a difficult process and it’s something that is commonly done when buying homes today. Your real estate agent or the manager of the escrow funds can answer any questions you might have about the account and keep you updated on the status, if needed, so you can make sure the funds are used appropriately.

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