An escrow account is a type of bank account held by a third party for the benefit of two other parties. While escrows can be used in just about any transaction, they’re frequently used in real estate dealings. Having a separate account for the money helps to protect both parties.
Purpose of an Escrow Account
Real Estate Transactions
When you buy or sell a home, your title, escrow or closing company almost always will open an escrow account. This account holds any money that comes in during the transaction that’s in a state of limbo, meaning it’s neither the buyer’s nor the seller’s. At the time of closing, the closer uses the escrow account to receive the funds from the buyer and the buyer’s bank, pay off the seller’s bank and any other charges, and give the seller his profit, if any.
When you refinance your mortgage, the title company typically opens an escrow account, the key function of which is to facilitate the process of paying off your old loan with the proceeds of the new loan. The account is designed to hold any good-faith deposit that you put into the deal. At the end of the process, leftover money will be disbursed it back to you.
A mortgage escrow account pays your taxes and insurance. When you make your monthly mortgage payment, a portion goes toward the principal and interest. The remaining funds get deposited into the escrow account so the mortgage servicer can withdraw the money periodically in order to make property-insurance and property-tax payments.
Non-Real Estate Transactions
Beyond real estate, escrow accounts typically get used in larger transactions where trust is an issue. For example, if you bought a car over the Internet, the seller is unlikely to ship you the car until you send her payment. On the other hand, you wouldn’t want to send her money until you had the car. Using a third-party escrow provider eliminates this problem. Once you send your money into the escrow service, the seller is notified. Once you confirm that you have the car, the money is released to the seller.
How Does Escrow Work
During the home buying process, the escrow process unfolds in four major steps:
- Two parties engaged in a transaction reach a point at which the process can move forward only if each is certain that the other will be able to fulfill his end of the agreement.
- The parties agree on a third party to serve as an escrow officer, also called an escrow agent. This third party is often from a bank, a law firm, a title company or the closing company. This varies by state.
- The parties agree in writing on the escrow process terms including a closing date, inspection and financing requirements and/or other contingencies.
- Once these conditions have been met, the escrow agent handles the disbursement of all monies, including realtor fees, mortgage payments, title and property insurance, prorated property taxes, recording fees and any liens. The escrow agent is paid according to state and/or mortgage vendor rules, the account is closed and the three parties have no further obligation to each other.
Escrow services are commonly used in real estate transactions to protect the buyer, seller and lender. Buyers can confidently submit earnest money and other required deposits to an escrow account without risk while details of the sale are still pending. Sellers are more protected against buyers walking away from the deal at the last minute because if that happens the seller can claim the earnest money the buyer placed in escrow. The buyer is protected because if the seller fails to properly address an issue raised during the home inspection, the earnest money remains in escrow until the seller satisfies the agreement.