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Escrow: How Does It Work?

Erin Gobler8-Minute Read
August 16, 2022

For many people, the home buying process is their introduction to lots of jargon used in the real estate and mortgage lending industries. One of those terms you’re likely to run into that might cause some confusion is escrow. Your real estate agent or lender might talk about earnest money or property taxes going into escrow, but what does that actually mean?

If you’re planning to buy a home, it’s critical that you understand what escrow is, how it works and how it affects you and your budget.

What Is Escrow?

Escrow is a legal arrangement in which a neutral third party holds funds until a particular condition has been met. At that point, the funds are passed along to their intended recipient. Escrow protects both buyers and sellers in the home buying process, so it’s advantageous for both parties when a home changes hands.

For example, an escrow company may hold onto your earnest money until a purchase agreement has been finalized. The seller is protected because they know they know the money has been paid. Likewise, the buyer can rest assured that if something goes wrong, they won’t have to worry about trying to get their money back from the seller.

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What Does Escrow Mean In Real Estate?

Escrow is commonly used in real estate so that a neutral third party can hold onto funds until it’s time for them to be delivered to their final recipient.

Escrow has several different uses in real estate transactions. First, as we mentioned, escrow is often used to hold onto a buyer’s earnest money until the home sale is complete. But escrow is often also used later, too, once the sale is complete. An escrow account might be used to hold a homeowner's property insurance and taxes throughout the year.

What Is An Escrow Account?

Escrow refers to the legal arrangement that allows the neutral third party to hold the funds for a certain period of time. But an escrow account is the actual location where the funds will sit. Think of an escrow account like a bank account – it’s a safe place to put money until you’re ready to use it. There are generally two different types of escrow accounts used in real estate, which we’ll discuss further below.

Escrow Accounts For Home Sales

The first type of escrow account used in real estate is in the case of home sales to protect the good faith deposit from the buyer. When you put your earnest money deposit toward your purchase, you signal to the seller that you’re serious about buying the home.

If you don’t follow through with the purchase, the seller gets to keep your money (except in certain circumstances, which are likely to be outlined in your purchase agreement). But if you move forward with the purchase, the earnest money will go toward the rest of the purchase price when you close on your home. Generally speaking, the earnest money ends up going toward  closing costs, like your down payment.

The escrow account, in this case, protects both the buyer and the seller. The seller feels protected because they know the earnest money has been paid. Even if the buyer backs out, the seller will likely still get the money.

The escrow account also protects the buyer by ensuring the seller doesn't get the money until the sale has been finalized. There are some situations – including appraisal or inspection contingencies – that allow buyers to back out of a sale and get their earnest money back. The seller could also back out of the sale. Because the money is in escrow, the buyer can trust they’ll get their money back if the need arises. On the other hand, if the seller got to hold onto the money, they might simply not return it.

Escrow Accounts For Paying Homeowner Fees

Escrow accounts are also used after a home purchase has been made. When you own a home, you’ll make monthly mortgage payments to your lender. Those payments cover your principal and interest owed, but they also typically include property taxes and homeowners insurance.

Taxes and insurance are paid annually or biannually. The money you pay for those costs each month goes into an escrow account, and then the escrow company passes it along to the appropriate parties when those bills come due each year.

Who Manages Escrow Accounts?

Escrow accounts are meant to be managed by a neutral third party. This party will be different depending on whether the escrow account is for earnest money or your property taxes and homeowners insurance.

The most important thing is that the party managing the escrow account is not the payer or payee of the funds.

Escrow Companies

In some cases, an escrow account may be managed by the mortgage servicing company or an escrow agent. This escrow company usually manages the account and analyzes it every year. And in the case of an escrow account to hold the earnest money, both the buyer and seller will pay for the management of the account. Often the escrow company in the case of earnest money is the title company or a real estate attorney.

Mortgage Servicers

For the escrow account that holds your property taxes and homeowners insurance, it’s usually your mortgage lender that manages it. The lender collects the share of your monthly payments that are owed to them and then places the portion for taxes and insurance into the escrow account.

Generally speaking, your mortgage lender will manage your escrow account as long as you have a home loan with them. Once the mortgage has been paid off, you’ll no longer be making payments to the lender. At that time, you may be responsible for paying those bills directly each year or setting up a separate escrow account to serve the same function.

How To Choose An Escrow Provider

While your lender typically manages your escrow account as a homeowner, as a home buyer, you’re usually in charge of deciding who to use for escrow. Usually, your real estate agent can’t be in charge of the escrow, nor can the agent representing the seller. And while the seller can make their own suggestions for an escrow provider, you, as the buyer, have the final word.

When it comes to choosing a provider, the most important things to consider are the escrow agent’s experience, the financial stability of the escrow company and the cost of the escrow services. In most cases, your real estate agent will be able to offer suggestions.

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The Pros And Cons Of Escrow

Escrow is a normal and important part of the home buying experience, but it still has its pros and cons. If you’re planning to buy a home, it’s important to understand how escrow might affect you.

Pros

  • Escrow offers protection: The most important benefit of escrow is that it protects both the buyer and the seller in case the other party backs out of the sale without cause.
  • Lenders make the payments: In the case of an escrow account for your property taxes and insurance, the benefit is that your lender makes the payments. You’ll never find yourself stuck at the end of the year trying to pull together enough money to make your property tax or homeowners insurance payment.
  • Payments occur on time: When your lender is the one handling your taxes and insurance through an escrow account, not only can you rest assured the money is there, but you can trust that your lender will make the payments on time.

Cons

  • Buyers may experience an escrow shortage: It’s important to know that the amount needed for your taxes and insurance is an estimate. Unfortunately, there could be a situation where your property tax or homeowners insurance bill comes due and there’s not enough money in the escrow account to cover it. This could happen if your taxes or insurance rates have increased since buying your house. In that case, you’ll be responsible for coming up with extra money.
  • You could have higher mortgage payments: If you have an escrow account, your mortgage payment includes your principal and interest, as well as the taxes and insurance going into the escrow account. That means your payments will be higher than what you may have initially estimated – if you didn’t include escrow in your calculation.
  • Your money will be tied up: When money goes into an escrow account, you won’t be able to touch it. Not only are you tying up your money for the entire year, but you also run the risk of overpaying. While you may be reimbursed, you could have used that money for something else throughout the year.
  • Large upfront payments: In many cases, mortgage lenders require an upfront payment for several months’ worth of property taxes and homeowners insurance to kick-start the account. This money will be due at the closing with your other closing costs and fees.

Escrow Example

Let’s say you’re shopping for a home and finally find the perfect one priced at $300,000. To show the seller you’re serious about buying, you offer 3% earnest money, which comes to $9,000. But as we’ve mentioned, you don’t simply pay that $9,000 to the seller. As an added layer of protection, the money goes into an escrow account until you’ve closed on the home.

When the home sale is finalized, the $9,000 will be used for part of your down payment, reducing the amount you’ll owe on closing day.

Once you close on the home, you’ll enter into another escrow account with your lender. Each month, part of your monthly payment will be set aside for taxes and insurance and placed in an escrow account. When the payments are due each year, your lender will pull from that account to pay your local tax entity and your homeowners insurance company.

Here’s an example:

Without escrow, your monthly mortgage payment is $1,000, which pays down your principal and interest. Your lender estimates that you will owe $6,000 total in annual property taxes and homeowners insurance for the coming year.  With 12 months until payment is due, you would owe $500 each month (6,000 divided by 12). With escrow, your monthly mortgage payment would be $1,500 per month.

Keep in mind that an escrow account, though similar to a bank account, doesn’t work quite the same way. You can’t simply deposit and withdraw money from the account anytime you want. Once the money goes in, it stays there until it’s sent to its final recipient.

Escrow FAQs

How do you remove escrow from your mortgage?

Many lenders require escrow as long as you have a mortgage on your home. Once you’ve paid off your loan, you’ll be able to remove the escrow. Some lenders may allow you to remove escrow before then, in some cases. Just know that if you remove it from your mortgage, you’ll be on the hook for your tax and insurance payments, and a failure to pay them could result in foreclosure on your home.

How much does escrow cost?

When it comes to the earnest money deposit, escrow fees typically amount to 1% to 2% of the home’s purchase price. So if you buy a house for $300,000, you’ll likely end up paying escrow fees of $3,000 – $6,000. When it comes to your taxes and insurance, the cost will depend on where you live and the type of homeowners insurance you choose.

What is an escrow disbursement?

An escrow disbursement refers to a payment out of an escrow account, normally to pay for property taxes and homeowners insurance. It usually comes from a lender on behalf of a borrower.

What do escrow accounts not cover?

Escrow accounts usually cover your property taxes and homeowner insurance for the year, but that’s it. Other expenses, including your HOA fees, utility bills, and other bills, are your responsibility to pay on your own.

What is an escrow holdback?

An escrow holdback is when additional funds are collected at closing in order to fix or repair a property. These funds could be paid by either the buyer or the seller, depending on the agreement (though in most cases, it’s the seller). The money will be refunded after the buyer or seller fixes the issue.

The Bottom Line

Escrow is an important part of the home buying process and often a necessary part of taking out a mortgage. There are two types of escrow accounts that occur at different points of the home buying process – one occurs during the process and the other occurs after.

There are certainly pros and cons to escrow, but most importantly, it protects all parties involved. Whether you see it as a pro or a con, know that it’s usually required.

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Erin Gobler

Erin Gobler is a freelance personal finance expert and writer who has been publishing content online for nearly a decade. She specializes in financial topics like mortgages, investing, and credit cards. Erin's work has appeared in publications like Fox Business, NextAdvisor, Credit Karma, and more.