What is Escrow and How Does it Work?

When buying a home, your escrow provider is a valuable member of your team. However, many home buyers and sellers can’t answer the question “what is escrow?” or explain how it works. 

In a real estate transaction, a trusted third party is hired to hold all documents and funds for both buyer and seller. This third party can be a law firm, title company, or escrow company, and the documents and funds are held “in escrow.” The escrow provider safeguards your funds and protects all parties by ensuring the terms of the purchase contract and mortgage agreement are carried out.

Let’s look at the various types of escrow accounts in the real estate process and how they work.

What Is Escrow in Real Estate?

When you sign a purchase contract, there may be an earnest money deposit involved. This is an up-front amount that comes from your down payment and shows the seller you’re committed to buying the home.

To protect both the buyer and the seller, the money is held in an escrow account managed by an independent and trusted third party until it’s time to close on your home.

Why do both parties need to be protected? 

When a seller accepts an offer, they take the property off the market. If the buyer backs out, the seller often keeps the earnest money as compensation.

If the seller does not meet the contract terms or are unable to deliver the home in the same condition as when the contract was made, the earnest money would be returned to the buyer, releasing the buyer from the contract.

The escrow officer or escrow agent follows through on these agreed upon terms and provides the funds to the appropriate party.

How Does Escrow Work?

In addition to the earnest money, the escrow account is typically used to hold funds for down payment and closing costs, credits back from the seller, and any other funds that are part of the transaction.

After the closing is complete, the escrow holder will distribute all funds as detailed in the real estate contract and mortgage agreement. These payments include real estate agent commissions, title and insurance fees, HOA dues, the purchase funds from your mortgage loan, and any other closing costs as detailed in your final Closing Disclosure.

The escrow agent carefully follows the details of the real estate contract and the written instructions of your lender so all funds get where they need to go.

Types of Escrow Accounts

Escrow accounts are common in real estate and are used widely in other business transactions as well.

There are two types of escrow accounts typically used in the real estate process.

As detailed above, the first type of escrow account is used to manage the transaction when you buy a home.

The second type of escrow is called a mortgage escrow account. 

Mortgage escrow account

A mortgage escrow account begins at loan closing and lasts for the life of your loan.

With a mortgage escrow account, you make monthly payments to the lender for your property taxes and homeowners insurance.

This money is added onto your monthly mortgage payment and is held by the mortgage company. They pay your property taxes and homeowners insurance when they are due.

Escrow accounts are typically required when you finance more than eighty percent of a home’s value, so most first-time buyers will enjoy the ease of budgeting provided by an escrow account automatically.

Non-real estate escrow accounts

Escrow accounts are useful in any situation where two parties want protection until agreed upon terms are met. Here are some non-real estate examples.

Renters Escrow

If you’ve ever rented an apartment or house, you know that landlords can sometimes fail to make necessary repairs or improvements in a timely fashion. A renter’s escrow account allows you to place your rent with a third party to be given to the landlord when the necessary repairs are made or working appliances are installed. This gives the renter some leverage to ensure their unit is repaired as promised.

Escrow and Online Shopping

The growth of online shopping over the past two decades has led to increased use of the escrow process for the protection of buyers and sellers. In this situation, the buyer puts the purchase price into an escrow account where it is held until the shipped item is received. Once the item is in hand, the funds can be released to the seller.

Escrow and Stocks

Stocks can be held in escrow for a variety of reasons. Frequently, stocks are held by a trusted third party during a merger, acquisition, bankruptcy, or reorganization. A company may, for a period, hold stocks in escrow that have been awarded to an employee. This is called a vesting period and is used as an incentive to keep the employee on staff.

Escrow Fees and How It Works

The cost of escrow fees will depend on the escrow company you use and the location of the home, but they will typically be one to two percent of the purchase price.

Because this service benefits both the buyer and seller, both parties typically pay a portion of this fee at closing.

The escrow fee will be listed on your Loan Estimate at the beginning of the process, and on the Closing Disclosure which you’ll receive before closing.

Benefits of Escrow

Escrow accounts offer several benefits to all parties in the real estate process.

First, placing all instructions and funds into the hands of a third party while under contract offers security to the buyer and seller, ensuring all contract requirements will be met and agreed upon money will be paid.

Second, real estate escrows provide assurance to the buyer, seller, and lender that — should the deal go south — no one’s investment will be jeopardized. Funds are protected and will be returned to the appropriate party.

Third, a mortgage escrow account assures you and your lender that your taxes and insurance are kept up to date.

Finally, the mortgage escrow account provides you with a stress-free process. Paying a predictable amount each month makes it easier to budget and you don’t have to worry about tracking the due dates for your taxes and insurance policies.

Escrow FAQs

Escrow is an essential part of a real estate transaction and mortgage process. Here are some commonly asked questions we see on a regular basis:

What is escrow on a house?

Escrow is an account that holds your funds for earnest money, down payment, and closing costs, as well as the purchase funds from your mortgage lender. At closing, all funds will be distributed to the applicable parties for a stress-free closing on your home.

How long do you pay escrow?

The real estate escrow fee is a one-time charge that you pay as part of your closing costs.

Your mortgage escrow is paid with your monthly mortgage payment to cover property tax and insurance payments. Mortgage escrows typically last the length of the mortgage.

Is escrow good or bad?

Escrow is a valuable and essential tool in the purchase process, providing security for both the buyer and seller of the property.

Mortgage escrows help the buyer manage their taxes and insurance payments. They are free of charge and provide easy budgeting for home buyers.

A Final Word

Your home purchase is one of the biggest investments you will make. Over the past century of buying and selling real estate in the United States, many processes have been put into place to protect the home buying process, as well as your homeownership rights. The escrow account is an essential tool that offers protection to everyone in the process.

If you’re still not sure what escrow is and how escrow works, or if you have other questions about your real estate transaction, contact us at homebuyer.com.

Dan Green

Dan Green

Dan Green is a former mortgage loan officer and an industry expert. He's appeared on NPR and CNBC, and in The Wall Street Journal, Bloomberg, and dozens of local newspapers. Dan has helped millions of first-time home buyers get educated on mortgages, real estate, and personal finance. Have mortgage questions? Ask Dan in the chat.

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