How Does Escrow Work in Homebuying

If you’ve bought a house or taken out a mortgage loan, you would be familiar with the concept of escrow accounts. So, how does escrow work? By placing funds in escrow with a third party, the buyer gains the ability to make an earnest money deposit. Additionally, escrow accounts assure the home seller that the buyer is genuinely committed to the purchase.

What is an escrow account?

Escrow, a legal concept, denotes a financial arrangement where a third party holds an asset or money on behalf of two parties engaged in a financial transaction. In real estate, escrow serves to safeguard the buyer’s earnest deposit and hold a homeowner’s funds for property taxes and insurance.

An escrow account can be a part of different transactions, for a home purchase process, taxes, homeowners’ insurance, mortgage insurance, and even in the stock market.

The escrow agent oversees these accounts, releasing assets or funds only upon fulfilling predetermined contractual obligations. Various assets, including money, securities, and funds, can be held in an escrow account.

What are the types of escrow accounts in real estate?

There are two types of escrow accounts utilized in real estate transactions:

Homebuyers escrow

This account is used to hold earnest money for both the homebuyer and seller. Once a homebuyer’s offer is accepted, typically 1% to 2% of the purchase price is held in this escrow account until the sale is finalized. The funds in this account commonly contribute to the down payment or closing costs. If the sale is successful, the escrow agent releases the funds and the property deed to the relevant parties. If certain conditions, like a home inspection, are not met by the seller, the buyer can withdraw from the deal and receive a refund. However, if the buyer backs out without a valid reason, the money may not be refundable.

Homeowners escrow

This account is established once ownership transfers from the seller to the buyer, and it is typically required by lenders. Loan lenders manage mortgage escrow accounts to ensure timely payment of specific mortgage-related bills by homeowners. Expenses such as homeowners insurance premiums and property taxes are added to the monthly mortgage payment and deposited into the escrow account. The lender utilizes the funds in this account to pay these bills on behalf of the homeowner, reducing the risk of late payments or property liens.

Is it always required to have an escrow account?

When purchasing a home, the necessity of an escrow account arises under specific conditions. For instance, homebuyers are mandated to maintain an escrow account if their down payment is below 20 percent of the home purchase.

Many times, mortgage lenders may require homebuyers to establish an escrow account. Especially, if the home is being financed through a government-backed loan, such as an FHA loan or a USDA loan. While the Veterans Administration does not stipulate escrow accounts for VA loans, the mortgage lender facilitating these loans may impose such a requirement.

How does escrow work in real estate? What are the steps?

Here are the steps to initiate the escrow process at the time of buying a house.

Open an escrow account

After you make a successful bid on a home and sign a purchase agreement, begin the escrow process. The escrow account can be opened by the seller or the buyer, usually within seven to 10 days of the contract signing. Remember that the earnest money stays in the escrow account until the final step, which is the closing. This money becomes part of your down payment on the home.

Get the home appraisal and home inspection

Your mortgage lender orders a home appraisal. If the home’s appraised value is less than the purchase price, adjustments may be needed. As the buyer, you can hire a home inspector to assess the property’s condition, including structural integrity, plumbing systems, and more. This is the time to review disclosures from the seller about known issues with the home.

Obtain insurance coverage

Your lender requires homeowners insurance and title insurance. Keep in mind that title insurance protects the lender from legal challenges related to the home’s title or ownership.

Do a final walkthrough

Before closing, ensure the home is in the expected condition. Check for any new damage. Make sure the seller has met the purchase contract terms. Also, confirm the water pressure in the house and check for plumbing issues.

Get ready for a closing

At least three days before closing, you will receive a closing disclosure with finalized costs. You can compare it to the initial loan estimate.

During closing, the escrow agent finalizes documents, names you as the homeowner, and wires funds to the escrow account for seller payments. Also, you’ll need a cashier’s check for the remaining down payment and closing costs.

How does escrow work in other financial transactions?

Escrow is used when two parties are doing a deal and there’s uncertainty about meeting their commitments. Let’s say a company is selling things internationally and wants to make sure they get paid when the goods arrive. On the other side, the buyer wants to pay only if the goods are in good condition. In escrow, the buyer can put the money with an agent who will only give it to the seller once the goods are in the right condition. This way, both parties are safe, and the deal can go smoothly.

Another example is when stocks are sometimes put in escrow. The shareholder, the true owner, has limited rights over selling the stock. For instance, executives getting stock as part of their pay often have to wait for an escrow period before selling it. This is a common practice to attract or keep top executives.

In online sales, escrow works similarly to real estate and stock markets, protecting both the buyer and seller from fraud or nonpayment. An online escrow service acts as a middleman for product sales. Buyers send money to the escrow service, which holds it until they get the product. Once the product is confirmed, the escrow service releases the funds to the seller. This is particularly useful for pricey items such as jewelry or art. Of course, the online escrow company charges a fee for this service.

Is escrow beneficial or not?

Escrow can be helpful in big money transactions, providing security for a fee. To better understand the role of this legal arrangement, let’s explore its pros and cons.

Pros

Ensures security in big transactions, especially in real estate.
Allows monthly payments for insurance and taxes, avoiding large lump sums.
Benefits both buyer and seller in significant transactions.

Cons

Results in higher mortgage payments when used for taxes and insurance payments.
In the majority of states, you are unable to accrue any interest on the funds within the escrow account.
Tax estimates may be incorrect. Your escrow company might predict an incorrect payment amount. In such cases, you may have to make a one-time payment to prevent an escrow shortfall.
Online escrow service fees might be higher.

Key takeaway

Escrow works by involving an impartial third party to hold assets or funds until they can be transferred from one party to another in a transaction. The third party retains the funds until both the buyer and seller have met their contractual obligations. While commonly linked to real estate dealings, escrow can be employed in various scenarios where the exchange of funds is involved. Especially, for high-value items such as stocks, art, or jewelry.

How does escrow work: FAQs

How much time does the escrow process take?

On average, it takes 50 days to finalize a real estate transaction. However, the duration of the escrow process can be influenced by factors such as the type of loan and the terms of the purchasing agreement.

Who manages an escrow account?

The escrow account can be managed by a title business, a bank, a financial firm, a private third party, or a real estate attorney.

What does escrow balance mean?

Your monthly payments are divided into principal, interest, and balance. The escrow balance enables the loan servicing company to withdraw funds from it to cover expenses such as taxes or insurance.

Can I, the buyer, select the escrow agent?

Yes, as long as the seller consents to the purchase agreement. Keep in mind that federal law prevents sellers from imposing their favored escrow or title company. That said, choosing a different company may lead to the seller rejecting your offer.

What happens if I refinance my home? Will I get a refund?

You are eligible for a mortgage escrow refund when refinancing your home, provided there’s no deficit in the account and you’ve consistently made on-time payments. Lenders are obligated to reimburse any remaining balance in your escrow account within 20 days of completing the mortgage refinance.

How does escrow work for homebuying and other transactions was last modified: February 7th, 2025 by Ramona Sinha

Written by Ramona Sinha. January 6, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.