What is escrow and why is it needed?

If you’re a first-time homebuyer, you’re likely to come across a lot of real estate terminologies that you’ve probably never heard before. Escrow is one of those words. In real estate dealings, escrow is used in a few different contexts. Let’s take a quick look at what escrow actually is, and why it is needed.

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What is escrow?

Escrow refers to a legal agreement between two parties, such as buyers and sellers, in which a neutral third party (usually an escrow company, escrow agent, or mortgage servicer) holds on to a substantial amount of money until certain conditions are met, such as the fulfillment of a purchase agreement. 

Types of escrow accounts

In real estate, there are two main types of escrow accounts that you will come across. The first one deals with buying a home, while the second one deals with paying taxes on your home. Let’s take a more detailed look at both of these.

While buying a home

When you make a purchase agreement as a part of finalizing the purchase of a home, a good faith deposit, or earnest money, is usually a part of the agreement. If the deal falls through because of your fault, the home seller gets to keep this money. Otherwise, it is considered a down payment against the property.

To protect both your and the seller’s interests, an escrow account is created to hold this money until the transaction is closed. It is then transferred to the seller as your down payment. 

In certain circumstances, the money may remain in the escrow account after the sale of the home is complete. This is known as an escrow holdback. This may happen, if for example, you find damages you want to be addressed during your final walk-through of the home, or if you’ve agreed to let the seller keep possession of the home for a stipulated time period after you’ve purchased the property.

For taxes

In some cases, your lender may deem it necessary to open an account to pay your taxes. Once closing costs have been accounted for, your mortgage handler or lender, as the case may be, will open an account and hold a portion of your mortgage payments until your property taxes and insurance payments are due.

The amount that is held in escrow is likely to change year on year, based on how much was paid the previous year. In order to make sure that your account always has enough cash in it, you may be required to make two months’ worth of extra payments.

At the end of each year, your servicer will audit your escrow account. If they find they have taken too much money, you will be given a refund. If they find they’ve taken too little, you will need to cover the difference.

Keep in mind, however, that your escrow account will not pay for expenses such as supplemental tax bills, utility bills, or HOA fees.

Do all home buyers need an escrow account?

Depending on your credit rating and type of loan, you could opt out of having an escrow account to pay your taxes and insurance. While that may lower your monthly mortgage payments, it puts the onus of saving for those expenses on you.

If you are buying your home using a VA loan and want to opt out of having an account, you will need to put down at least 10% as a down payment and have a really healthy credit score.

Conventional loan lenders require you to be able to put 20% or more down payment to avoid an account, while it is mandatory for all borrowers of FHA loans to have an escrow account.

Read more: Defeasance clause

Is an escrow account good or bad?

A comparative analysis ought to be able to answer this question for us.

Disadvantages

1. It is likely to cost you more on your monthly mortgage payments.
2. The amount you need as escrow payments to pay may vary from year to year.
3. If your audit shows you’ve paid less, you will need to cover the deficit.

Advantages

1. As a home buyer, an escrow account protects your earnest money. If you pay it directly to the home seller and the sale falls through, you may not always get it back.
2. As a part of the home buying process, escrow servicers also take on the responsibility of paying off a number of additional fees, such as real estate agent fees, prepaid mortgage interest, and recording fees.
3. As a homeowner, an escrow account takes away the pressure of coming up with large amounts of money year on year for property taxes and homeowners insurance premiums by taking it in monthly chunks as a part of your mortgage payments.
4. An escrow account protects your lender as well. Let’s suppose your home suffers damages due to a natural calamity and you’ve defaulted on your homeowner’s insurance premium. Your lender stands to lose a lot of money. Your lender also stands to lose if you default on your tax bills and the tax authority decides to foreclose. 

 While an escrow is unnecessary if you have a strong financial profile, it is otherwise a protective blanket that reduces risks for all parties involved in real estate transactions.

Written by Narayan Shrouthy. August 7, 2021

Narayan is a content writer for Kukun. With experience in both content writing and editing, Narayan mixes his writing and love for reading with his passion for music. As an active musician, He aims to be a key player in Kukun's content experience.