Explained: What is Escrow?

When buying a home, there are certain terms you simply must understand; escrow is one of them. 

In general, the term escrow applies to a financial arrangement in which an independent third party holds assets (cash, paperwork, etc.) on behalf of a buyer and seller until the conditions of that financial arrangement are fulfilled. This helps to ensure that neither party is taken advantage of should either fail to hold up their end of the bargain.

In real estate transactions specifically, however, escrow refers firstly to the earnest money put forward when a buyer intends to purchase a particular property. This initial deposit, which serves as a good-faith measure to show the buyer is serious, is held in an escrow account typically managed by either the buyer’s real estate agent or the title company. As the buyer prepares for closing, they are then expected to provide the first year’s insurance payment as well as a portion of the property taxes. These funds are housed in the account from which the lender will then pay the borrower’s home insurance and tax bills.

How Is Escrow Determined?

The amount of homeowner’s insurance and taxes are estimated each year by the lender, and these amounts are added on to the mortgage payment each month. Often, these amounts are either a bit over or under the actual monies needed for the year. When this occurs, the lender notifies the borrower of either the shortage or overage via an annual escrow analysis. Shortages are essentially sent in the form of a bill requiring the homeowner to fully fund the account within a set period of time. Overages that are higher than the allotted amount are sent in the form of a refund check, a nice little pat on the back after a long year of paying your bills. It should also be noted that following an escrow analysis, the monthly payment amount is commonly adjusted to better anticipate the coming year’s taxes and insurance.

Why the Extra “Escrow” Step?

So why even bother taking the extra steps to set the whole thing up? Wouldn’t it just be simpler for the homeowner to handle the bills on their own? Upon first glance, it might seem that way, but there are two really compelling reasons that suggest the escrow option makes the most sense – it’s safer for them (the lender) and easier for you (the homeowner).

When financing a house, there is a lot of money on the line, and any lender worth their salt wants to make certain that the very large piece of collateral (the house itself) doesn’t say, burn to the ground with an overdue and thus defunct homeowner’s insurance policy. Additionally, a good mortgager should avoid the possibility of some local municipality taking over and forcing a tax sale when property tax bills go unpaid. Securing these funds through an escrow account is the best way to do this.

As for the homeowner, wouldn’t you appreciate the help? Buying a house brings enough responsibility in and of itself with multiple utility bills and a brand new mortgage payment. Having one (or in this case, two) fewer thing on your plate as you make the transition to new homeowner can be quite helpful.

While the world of escrow might seem like an unnecessary step on the path to homeownership, it is actually a nice safeguard for everyone involved. It allows both the buyer and seller to feel at ease during the negotiation and closing process, and following the sale, it provides additional assurance to the borrower and lender that all necessary bills are paid to keep the very precious collateral (your beloved new home) protected.