As you dip into the home buying waters, you may hear the term “escrow” being thrown around. As a homeowner, you’ll typically be set up with a mortgage escrow account, which will serve you throughout the life of your mortgage. In the early stages of buying a home, an escrow account is used to hold your down payment until closing.
Understanding how escrow works can help you navigate the home buying process and budget for payments once you get your mortgage.
What Is Escrow?
Escrow is a third-party legal arrangement that temporarily holds onto money during the home buying process and releases it when a particular set of conditions have been met.
Let’s say you make a friendly wager. You may ask a neutral friend who’s not involved in the wager to hold onto the money for you. Escrow is the legal version of that neutral friend.
What Is an Escrow Account?
An escrow account is essentially a savings account that’s managed by a bank or title company. The account is used to set money aside, ensuring the soon-to-be homeowner can meet their financial obligations. These costs include property taxes, homeowners insurance, mortgage insurance and other expenses connected with homeownership.
How Does Escrow Work?
When you’re buying a home or making another real estate transaction, you may need to make a good-faith deposit (aka an earnest money deposit). This deposit is placed into your escrow account to show that you intend on completing the deal. It usually equals 1% – 3% of the home’s sale price.
How do escrow payments work
What you pay to your escrow account depends on the cost of your property taxes, homeowners insurance and mortgage insurance. Since these expenses are paid annually or semiannually, you should aim to save a fraction of the total cost each month.
Say your property taxes are $5,000 a year, and your homeowners insurance is $1,000. That’s $6,000 for the year. When you divide $6,000 by 12 months, it comes out to $500 a month. That’s what you (or your escrow account manager) should aim to set aside each month.
Why earnest money is held in escrow
Earnest money signals to the seller that you’re serious about buying the home. Once the good-faith deposit is in the account, the seller can’t accept any other offers. After you close on the home, the deposit can be applied toward your down payment or closing costs.
Getting escrow money back before closing
Buyers can get money back from escrow if financing falls through, problems are discovered during the title search or home inspection or the home appraisal is lower than the sale price.
But if you, as the buyer, are responsible for the contract falling through, the seller usually gets to keep the money. So work with your real estate agent to ensure you’re meeting all your obligations.
Close of Escrow for Mortgage
The close of escrow is the point in the real estate transaction when the buyer, seller and all participating parties have fulfilled their legal responsibilities to one another. This is a regular occurrence in most real estate transactions.
Difference between close of escrow vs. closing date
While the close of escrow is closely connected to the closing date, they aren’t always the same thing. This is because not every aspect of the transaction may be achieved on the closing date. So while you may have had your closing date, you may not officially reach the close of escrow until later.
Common issues that can occur during close of escrow
The escrow process is designed to allow both the buyer and seller the opportunity to resolve any last-minute issues. So everyone can walk away satisfied with the agreement. However, there can be other issues that get in the way or delay close of escrow, including:
- Delays: Missing paperwork or issues with a contract clause can cause delays. In this case, either party can request a closing date extension, pushing back the closing date until everything is resolved.
- Title issues: Performing a title search may reveal a “cloud on title” – an issue that puts ownership of the home in question. These can range from a clerical error to a lien on the property, which may threaten a clean transfer of ownership.
- Contingencies: When you and the seller negotiate your purchase agreement, it will likely include contingencies – conditions that need to be met before the sale can go through. Depending on the nature of the contingency, the buyer or seller may cancel the deal, request a delay or waive the contingency to allow closing to move forward.
How to achieve close of escrow
Of course, the close of escrow doesn’t happen overnight. Before you can achieve the close of escrow, you’ll need to go through the following stages:
- Deposit earnest money: After you and the seller sign a contract or purchase agreement, you’ll need to make an earnest money deposit.
- Agree with the seller’s disclosures: When you buy a home, you may receive a seller’s disclosure or property disclosure from the seller. The disclosure details the condition of the home and lists any known defects or previous events you should be aware of. Once you agree with the disclosure, you acknowledge that you have been informed and still want to buy the home.
Not all states require seller’s disclosures. Instead, some have a caveat emptor (buyer beware) rule, which means you have to do the research yourself.
- Finish inspections and home appraisals: Even with a full seller’s disclosure, you’ll want a home inspection to make sure there aren’t any problems with the home. Your lender will also request a home appraisal to ensure the home you’re buying isn’t worth less than the amount you’re borrowing to buy it.
- Review all documents: You’ll also want to do a final review of all documents associated with the sale of the home, including the transfer deed, bill of sale, a seller’s affidavit, signed mortgage deed, mortgage application and the Closing Disclosure. These documents should be reviewed by your real estate agent or a real estate attorney.
- One last walkthrough: Before you sign, do a final walkthrough of the property. This is your last chance to look for any damage and make sure the seller met all of the terms agreed to in your purchase agreement or contract. You can’t back out unless there’s major damage, but if you find problems, you may be able to renegotiate with the seller before closing.
- Sign the closing documents: Once you’ve performed your walkthrough, it’s time to close on your home. This is where you and the seller sign all of the documents, pay any outstanding fees and make your down payment. Once that’s done, you get the keys, and the home is yours.
Mortgage Escrow Accounts for Taxes and Insurance
After you close on your home, your lender or loan servicer will set up a new escrow account for your taxes and insurance. This type of escrow account is used to collect and manage the funds needed to meet specific obligations throughout the life of your mortgage. An escrow account covers:
- Estimated property taxes
- Insurance premiums, including homeowners insurance and mortgage insurance
Escrow accounts don’t cover:
- Utility bills
- Homeowners association fees
- Supplemental tax bills
How does your mortgage escrow account work?
To ensure you can cover your property taxes and insurance payments, you must maintain a minimum balance in your escrow account. According to federal regulations, your escrow account should have enough money to cover:
- Annual insurance and property tax bills
- A cushion of two extra monthly payments
- An extra $50
What are escrow adjustments and refunds?
Let’s say your property taxes are reassessed or your mortgage premiums are readjusted, and the amount you need to pay goes up. Your mortgage lender may increase your escrow payments to ensure there’s enough money in your account to cover your new payments.
If the amount you need to pay goes down, your payments may go down – and you may even get a refund!
The Pros and Cons of Using Mortgage Escrow Accounts
Using a mortgage escrow account to buy a home is standard operating procedure. But when it comes to using a mortgage escrow account to cover property taxes and insurance, you may be able to opt out.
Opting out of using an escrow account will make your monthly mortgage payment lower, but you’ll have to make separate payments for property taxes and homeowners insurance.
If you decide to go with a mortgage escrow account, your lender may offer you a discount on your interest rate or closing costs.
With a mortgage escrow account, you won’t be left wondering how much you need to set aside or if you set enough money aside to cover your property taxes. By using an escrow and letting the lender manage payments, you can save yourself the stress of missing payments or being short on funds.
When you set up a mortgage escrow account, you might pay upfront to cover several months of property taxes. That can add to your closing costs when you buy your home.
While the money sits in an escrow account, it earns interest like any other savings account. That interest goes to the lender.
Many mortgage servicers charge a waiver fee for opting out of escrow payments. Check to see if that’s the case before deciding to make payments on your own.
Who Manages the Escrow Account?
During the home buying process, your real estate agent (or the seller’s real estate agent) will set up an escrow account through a title company, bank or credit union.
Once you’ve closed on your new home and start making mortgage payments, your mortgage lender (or loan servicing company) is responsible for setting up an escrow account to handle your taxes and insurance.
When you get your mortgage statement, you’ll see that your payment includes the principal, interest and an additional escrow payment. The lender or servicer deposits these funds into your escrow account. When your property taxes or insurance payments are due, the lender withdraws money from the escrow account to make the payments.
Opting Out of Escrow
Most homeowners find escrow accounts convenient. They can help make your monthly payments more manageable.
But if you’d prefer to not make an escrow payment, there are circumstances where you can choose to opt out. This will make your monthly mortgage payment lower, but you’ll have to make separate payments for property taxes and homeowners insurance.
Also, some mortgage servicers charge a premium for opting out of escrow payments. So check before deciding to make the payments on your own.
Final Thoughts on Escrow
Escrow is often a major part of the home buying process. And while it may seem complicated, it can make your life easier by helping ensure you can meet all the financial obligations of your mortgage over the life of your loan.