What is escrow and how does it work?

You’re navigating a home purchase and, as if that’s not stressful enough, you frequently run into unfamiliar real estate terminology like “escrow.” What does that mean exactly and how does it affect you as a buyer?

Escrow is commonly used in real estate (and sometimes even outside real estate) to protect buyers, sellers, homeowners, and lenders. Here’s what informed buyers need to know about how escrow functions in real estate, and the impact it can have on each party.

Escrow explained

Escrow is a service where a neutral third party — often an escrow agent — holds funds or property until certain conditions are met. Once those conditions are met, the escrow company distributes the funds to the appropriate party. 

If you’re buying a home, you’ll likely use escrow services, which can help protect both you and the seller during the transaction. You’ll also probably encounter escrow services once you start paying your home loan, as many lenders use escrow accounts to collect money for your property taxes and homeowner’s insurance (more on this in a bit). Whether you or the lender pays these bills is something you’ll decide with your lender when you take out your loan.  

What is an escrow account?

An escrow account is simply an account that’s set up to hold and distribute money, typically for one of two major purposes: 

1. Real estate transactions: An escrow account that holds onto the buyer’s deposit during a real estate purchase, to be distributed according to the terms of the contract. This type of escrow account is often set up by your closing agent or attorney, and the cost may be split between the buyer and seller. 

2. Mortgage servicing: An escrow account that collects and holds money from your mortgage payments to pay for homeowner’s insurance and property taxes. This type of escrow account is usually set up by your lender or mortgage servicer. 

Escrow account for real estate transactions

Let’s say you make a winning offer on a home and include a 3% good faith deposit, also known as earnest money. This deposit will usually go into an escrow account for safe keeping while you get an inspection, finalize any negotiations with the seller, and close your home loan. Once all conditions of the contract are adequately met between you and the seller, and you head to the closing table, the deposit should be applied to your down payment. 

What happens if the conditions of the contract aren’t met, or one of the parties backs out of the deal? Who gets the earnest money then? That depends on what’s outlined in the contract and which contingencies you have in place. 

For example, if you have a financing contingency and you can’t secure a mortgage to buy the property, you can typically walk away with your earnest money intact. Or if you have an inspection contingency built into the contract and the report turns up multiple major repairs, you may be able to back out of the contract with your deposit money. However, if you just get cold feet, the seller will likely get to keep the earnest money. 

Whatever happens, your purchase contract will dictate who gets to keep the earnest money, and the escrow company will see to it that the proper party gets paid. 

The escrow company may also be responsible for holding onto important documents like the deed during the transaction.   

Escrow account for mortgage closing

Escrow can also come into play after you close, once it’s time to start making your mortgage payments. If you and your lender decide to escrow property taxes and insurance, you’ll make monthly payments into an escrow account, and pay a little extra each month to go toward your yearly property taxes and insurance. How much extra you’ll pay each month for taxes and insurance depends on a variety of factors, including your location, the specifics of your property, and which insurance company you choose to work with. 

For example, if  your property taxes are $4,000 per year, and your homeowner’s insurance costs $1,400, you can expect to pay an extra $450 per month for each mortgage payment. That money will sit in escrow until the time comes to pay for taxes and insurance. Then your mortgage servicer will make those payments for you. That means you don’t have to worry about sending checks. 

If the cost for taxes and insurance ends up being less than what you paid into escrow, you should get a refund from your servicer. If you didn’t pay enough to cover these costs, then you’ll get billed for the difference.

Also keep in mind that escrow services don’t cover every expense for homeowners. Homeowners association (HOA) dues, utilities, supplemental tax bills, and municipal service charges will likely need to be covered separately.

Pros of escrow

Escrow is a service that has benefits for buyers, sellers, homeowners, and lenders alike. 

• Protects the buyer and seller in a real estate transaction: Both parties are protected in the transaction. If the buyer needs to back out of the deal for reasons that are outlined in the contract (like the appraisal comes in below the purchase price), they can do so with their earnest money. The seller, on the other hand, is protected in case the buyer tries to back out for reasons that are not included in the contract.

• Helps homeowners manage payments: When you escrow your tax and insurance payments, you don’t need to remember to save up for them or be responsible for sending a check when they are due. The servicer is responsible for ensuring everything is done on time. Sure, you have to set aside a little extra money each month, but that helps keep the payments manageable over time.  

• Safeguards the lender’s investment in your property: If you don’t pay property taxes, you could have a tax lien placed on your home. And if your homeowner’s insurance lapses and something unexpected happens — like a fire damages your home — you (and your lender!) could be out a lot of money. This is one major reason why many lenders prefer to use escrow, to protect their investment in the property. 

Cons of escrow

Escrow doesn’t have too many cons during real estate transactions, but there may be a few potential drawbacks for homeowners.

• Higher monthly payments: You’ll pay estimated property taxes and homeowner’s insurance with your monthly mortgage payment, which will mean paying a higher amount each month. But this “downside” may be more of an upside in disguise — nobody wants to get hit with a massive bill each year that they didn’t adequately plan for.

• Estimated payments could be off: Property taxes and homeowner’s insurance aren’t static costs, meaning they could go up or down each year. What you pay into escrow each month is usually based on the previous year’s costs. So if costs rise, you may need to kick in extra for the difference. This could create an unexpected cost if, for example, property valuations in your neighborhood rise dramatically and you’re hit with a higher tax bill than you anticipated.

• Monthly payments may change: Speaking of property and insurance costs unexpectedly rising, that could also affect your mortgage payments going forward. Typically the servicer will assess your costs each year and use that as the model for the following year. So if, for example, your property taxes are raised $1,200, you can expect your mortgage payments to go up by around $100 per month the following year. 

Do you need to escrow tax and insurance payments?

I will depend on the specifics of your home purchase. Many lenders do require escrow, and for some loan types, it’s not possible to opt out of escrow. FHA loans, for example, require escrow. If you get a conventional loan and put down less than 20%, you’ll likely be required to use escrow. Check with your lender to find out your escrow options.  

Wrapping up 

When it comes to buying real estate, escrow is an important piece of the puzzle. It’s meant to protect you and your investment, and ensure all relevant parties are paid at the right time. If you’re buying a home, you’ll likely use escrow services during the real estate transaction and after you close and start making monthly mortgage payments. 

This content is meant for informational purposes only and is not intended to be construed as financial, tax, legal, or insurance advice. Opendoor always encourages you to reach out to an advisor regarding your own situation.