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What is Escrow and How Does it Work?

February 17, 2022
Street scene of homes at Savannah in Audie Murphy Ranch in Menifee, CA

Have you ever wondered what it means when a home is “in escrow?” Escrow can be an exciting term to a buyer and the seller of a house. It indicates that a sales agreement has been signed by a home seller and a buyer.

In real estate, escrow can also be used throughout the life of a mortgage. How does escrow work when you’re selling or buying a house?

Here’s what escrow is, how escrow works and helpful things to keep in mind.

What is Escrow?

Escrow is a legal term that indicates a third party is holding money or an asset on behalf of two parties who are finalizing a transaction, including the sale and purchase of a home.

When both parties have fulfilled their contractual requirements, the third party releases the funds to be transferred from one party to another. The homebuyer and the home seller often split the fees for the escrow service.

Escrow is used to help ensure all parties are protected throughout the transaction.

When a Home is in Escrow

When a home is “in escrow” in real estate, it means a legal procedure is taking place for the transfer of the property title. An escrow officer may handle the exchange of money.

They may additionally handle the property transaction and any related documents, such as the buyer’s loan documents and property deeds. For the homebuyer, an escrow officer may work with the buyer’s lender to ensure the home title doesn’t have any liens on it before the ownership transfer is completed.

Escrow Accounts

An escrow account is typically opened by the listing or buyer’s agent when the property seller and homebuyer have agreed on the selling price and terms of the sale. Money the buyer puts toward the down payment in good faith is typically added to an escrow account.

After the seller and buyer have signed the sales contract, the seller cannot accept offers from others who may be interested in buying the property.

Earnest Money

In real estate transactions, a buyer may place a portion of their homebuying funds, called an “earnest payment,” in escrow to demonstrate that they are serious about purchasing the home. This amount is typically around 1%-2% of the home’s final purchase price.

When the home sales closes, the earnest payment is applied toward the purchase of the home. If conditions that were agreed upon in the sale contract aren’t met, the buyer may get the earnest payment back under certain circumstances. Escrow accounts may be used when you’re building a new home, too.

If the buyer can’t fulfill their obligation to the contract or changes their mind about purchasing the home, the seller may get to keep the money that’s in escrow.

In addition to the use of escrow during the home sale and purchase, a homebuyer may use an escrow account with their mortgage lender.

How Escrow Relates to Mortgages

Escrow in real estate may also apply to escrow accounts that are set up when a mortgage closes. These are called impound accounts in some states.

Some lenders require this type of escrow account. It ensures that the homeowner is covering all the payments they’re legally obligated to make. It is used to hold funds for future property tax payments and homeowners insurance.

Out of this account, the mortgage holder’s property taxes and homeowners insurance are paid. The mortgage holder usually pays a small fee for this service.

Escrow Service Accounts

Homebuyers will often request an escrow service account. The benefit is that you’re putting away money for taxes and insurance in future months instead of having to pay a bigger bill once or twice a year. Failure to pay property taxes can result in a homeowner possibly losing their home.

Additionally, failure to pay homeowners insurance and property taxes can result in your lender adding an escrow account to your loan anyway, or adding the amounts you failed to pay to your loan balance. The lender may then have to purchase homeowners insurance for you and bill you for it, which could result in more expensive homeowners insurance than you’d pay for on your own.

Escrow is a Typical Part of the Homebuying Process

If you’re purchasing a home, you’ll likely encounter escrow at some point in the sales process. Escrow protects both homebuyers and home sellers.

Want more homebuying resources? Check out Brookfield Residential blogs or locate your next dream home. Brookfield Residential builds homes in locations you’ll want to live.