What is escrow? This is when a third party holds onto money during a real estate transaction. You can’t touch this money and neither can the seller. However, having these funds in a neutral account protects both sides, by making sure the property transaction happens “all at once” at the closing table.
Your mortgage lender may also require you to set up an escrow account for other purposes, but more on that later.
Who Is This Third Party?
The answer varies from state to state. It could be an attorney, a closing agent, a title company, or your lender (in the case of lender-required escrow accounts). Ask your buyer’s rep who typically handles escrow accounts in your area.
How Much Does Escrow Cost and Who Pays?
Escrow service fees are only one part of your total closing costs, and these fees vary from state to state, and from one company to another. While certain regulations may apply to the third party handling an escrow account, it’s more likely that the decision of what to charge is governed by standard practices in your area.
Depending on how you’ve negotiated your sales agreement, escrow fees and other closing costs could be paid by you, by the seller, or an equal split (or another agreed-upon percentage for each). Ask your buyer’s agent what is standard in your area and how this is negotiated.
What If I Decide Not to Buy?
When you put up “earnest money” in an escrow account, you are promising that you are going to purchase a home—and your earnest money would go to the seller should you back out without a legitimate reason. (This is one reason why most real estate contracts include a “subject to inspection” purchase clause.)
The amount of earnest money held in escrow varies, but is generally one to two percent of the price of the home. It may be higher in high-demand markets, where sellers have more leverage and can ask for more earnest money. This is understandable, since they may have missed multiple opportunities to sell their home if you back out.
If you do complete the purchase, your earnest money will go toward your portion of the closing costs, or your down payment on the house.
Also, if your transaction doesn’t close, a cancellation fee is usually retained by the third party. Be sure your purchase agreement specifies how (under what circumstances), when, and how much you (or the seller) will receive if the purchase isn’t finalized.
How Do Lenders Use Escrow?
Escrow accounts are also used by lenders to protect your home (which, from a bank’s perspective, is the asset backing up your loan). Lenders want to make sure taxes and insurance are paid, so they add these amounts to your monthly mortgage payment and place the reserve funds in an escrow account.
When the insurance and taxes are due, the payment is made from the escrow account. This ensures that your property is protected from loss (due to fire/flood/disaster) and that it is safe from foreclosure as a result of unpaid taxes.
In the case of a lender’s required escrow account, the account may be maintained for the full term of the loan or until a certain percentage of your loan has been paid. Ask your lender for their requirements.
Lenders may also give other names to escrow accounts: prepays, reserves, impound.
Do I Have to Use Escrow to Buy a Home?
That depends on your location and your lender. In some states, the real estate brokerage holds onto your earnest money. In other areas, it is standard practice to use an escrow agent, the title company, or another third party.
If you aren’t using an escrow agent, it will be up to you (and/or your lawyer) to distribute all the funds and make sure everyone gets what was agreed upon to complete the transaction at closing.
Also, if you are paying cash for the house, there’s no lender to require a mortgage escrow account after the sale, since you are taking full responsibility for any risk if you don’t carry insurance or pay your property taxes.
How Do I Fund My Escrow Account?
During the home buying process, earnest money is paid by you, usually by check.
For lender-required escrow accounts, the pro-rated cost of insurance and taxes is usually included in your monthly mortgage payment, so you only have to write one check (or one electronic funds transfer) each month.
Do I Earn Interest on My Escrow Account?
Escrow accounts are not required to earn interest, although some banks may offer interest-bearing escrow accounts. This is a question for your lender or your escrow company.