What is Escrow and Why is it Important as a Home Buyer?

Aug 14, 2019Home Financing

No matter where in the country you're buying, you're sure to encounter escrow at some point in the home transaction. If you're entirely new to buying a home, then buzzwords like this can sound scary at first. But don't worry, it's not as bad as it sounds. Escrow simply refers to when something of value is being held by a third-party during the transaction. Usually, this is the earnest money deposit and the contracts. However, the term also has several other meanings in real estate. But they all essentially boil down to your house and your money being in a sort of limbo.  

Let's take a closer look at what escrow means, and why it's so important to understand it when looking to buy a home.

How Escrow Works

As mentioned, escrow is when a third party holds onto the earnest money deposit while a home purchase is in contract. The term also refers to the third party themselves. Their job is to ensure that all parties are protected until the transaction is complete on closing day. If any conditions in the sales contract are not met by one party, then they won't be receiving any cash or house until they are. An easy way to think about escrow is to imagine it's a good-faith deposit. It shows the seller that you're serious about your offer because if you back out now and break the contract the escrow amount will compensate the seller for lost time.

The person or company who acts as the escrow agent will usually be someone from either the closing company, an attorney, or a title company agent. The exact customs will vary by state so make sure to check what the law says about yours. 

As the transaction proceeds, documentation will be sent to the escrow agent informing them that conditions have been met. For instance, if the sales contract included a home inspection contingency, then until the seller has received a green light from an inspection officer, they can't move forward with the deal. Once all conditions of the contract have been met, a closing day can be scheduled, and the deal finalized. The cash held in escrow will be released to the sellers, and the buyers will receive the property title, making the home officially theirs. 

How Much Does Escrow Cost?

The exact escrow amount will vary but is usually about 1-3% of the sales price. The exact amount will be predetermined in negotiations, so you'll know what to expect. 

Can You Borrow the Escrow Amount from Your Lender?

You can, but it comes with certain rules in place depending on your lender. Most first-time buyers will need to go to their lender for their earnest money. Your lender will count this amount as part of your down payment.

What is an Escrow Account?

Escrow also has a part to play after the transaction is complete. If you purchased with a mortgage, then your loan officer will require you to have an escrow account. This will be used to pay property taxes and home insurance charges incurred as a homeowner. Your loan officer will have direct access to your account and make these payments for you. This is important because a loan officer can't risk you falling behind in taxes and getting a lien on the property. The same thinking also applies to home insurance where the lender can't risk you missing a payment and potentially losing coverage on your property.

An easy rule of thumb for home buyers is to expect to pay two months' worth of expenses on an escrow account when you first close on the property. Your lender will then usually review your escrow account once a year to ensure you have enough to cover your payments.

Final Thoughts

Escrow might feel like a pain, but it serves a vital purpose of protecting the buyer and seller. If the seller fails to meet any contingencies, they won't see a dime of the buyer's money until they do. If a buyer gets cold feet and breaks the contract to exit the deal the seller will at least be compensated for their lost time by getting to keep the earnest money deposit. This is why the earnest money amount is as high as it is, without enough skin in the game, the buyer has little reason to keep to the contract. Usually things will go smoothly, but it's nice for both parties to know that their interests are being protected.


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