If you’re in the process of getting a mortgage to buy a house, you will hear the term escrow quite a few times.
An escrow is a legal arrangement. In this arrangement, a third party holds money or property until a certain condition is met. When we’re talking about a mortgage, this could be fulfilling your purchase agreement.
Within real estate, in particular, escrow protects buyers and sellers in the transaction. With the mortgage, the escrow account also holds the funds for homeowner’s insurance and taxes.
There are two types of escrow accounts in real estate, as mentioned—the first is to protect your good faith deposit. That means the money goes to the right party based on the conditions of your sale. The second is to hold funds that will cover the property taxes and homeowner’s insurance.
Escrow Accounts for Buying a House
When you buy a house, you’ll sign a purchase agreement. That purchase agreement usually includes earnest money, also known as a good faith deposit. This is meant to show you’re serious about buying the house. You might include a personal check of 1-2% of the purchase price when you make an offer on the house, although it can be more depending on the market.
If your contract falls through and it’s your fault as the buyer, the seller will probably get to keep this money. If your offer is rejected, you get the money back.
If the home purchase goes through, then the deposit gets applied to your down payment as the buyer.
An escrow account is set up to protect a buyer and a seller, and the deposit is held there. Your good faith deposit stays in this escrow account until you close, at which point your cash goes toward your down payment.
The funds might be held in escrow beyond the sale of the home, which is an escrow holdback. An escrow holdback can happen for a number of reasons. For example, maybe when you did your final walkthrough, there was something wrong with the house.
If you buy a new house, the money might stay in the escrow account until you sign off on the work, and then when the conditions are met, the money is released.
Taxes and Insurance
After buying a house, your lender sets up an escrow account from which your insurance and taxes are paid. Once your closing is complete, the mortgage servicer takes part of your monthly mortgage payment, holding it in the escrow account until your insurance and tax payments are due.
The amount needed for escrow changes. Your tax bill and your insurance premiums can change yearly.
Your servicer determines your escrow payments for the upcoming year based on what they paid the previous year. To ensure there’s enough money in escrow, lenders usually require at least two months of additional payments to be held in the account.
Lenders will check an escrow account annually to ensure they aren’t collecting too little or too much. If they determine when analyzing it that they’ve collected too much for your taxes and insurance, they’ll give you an escrow refund.
If they collected too little, you might need to cover the difference.
Who Manages These Accounts?
A third party manages an escrow account. This might include an escrow company or agent or a mortgage servicer.
If you’re buying a house, your escrow will probably be managed by a mortgage service company or maybe an agent. The agent or company may be the same as the title company.
The escrow company will manage the deposit you put down as a buyer, and they might also hold the deed and any other documents that relate to the sale of the home. Since the escrow company works for the buyer and the seller, the fee is often split between the two.
Your mortgage servicer manages your mortgage from when you close until you pay it off. A mortgage servicer is responsible for collecting mortgage payments and maintaining the records of your payments, along with managing the escrow account.
Finally, an escrow account doesn’t cover all homeownership expenses. For example, your lender or mortgage servicing company isn’t going to collect the money to pay your HOA fees or utility bills. There are also supplemental taxes not covered by escrow accounts, and lenders don’t know when you’ll get one of these or how much it will be so account for this.