One common term that often comes up during the home buying process is escrow. In this article, we’ll discuss five things to know about escrow and answer the question, how does escrow work?
If you’re thinking about escrow, that means you have decided to purchase a home. So, while it will be fun to think about paint colors, kitchen tile, and new furnishings, you will also have to consider the practical aspects of buying a home. This is where escrow comes in so let’s take a deep dive into what escrow is and how escrow works.
What Is an Escrow Account?
Escrow is a financial arrangement between two or more parties engaged in a transaction, such as buying a house, who agree to let a third party temporarily hold onto money or property on their behalf. The third party, who can be a law firm, an escrow company, or a title company, holds the money or property until the transaction is complete. This is known as holding the money “in escrow.” Most escrow accounts are used for real estate contracts, and they provide protection for both the buyer and seller.
How Does an Escrow Account Work?
There are two main types of escrow accounts in real estate: mortgage escrow accounts for home buyers, and life of the mortgage accounts. Let’s take a look at both.
Mortgage Escrow Account for Home Buying:
The mortgage escrow account applies to home buyers who take out a mortgage. The lender you use will most likely require this account if you cannot pay more than 20% down for the property. How does escrow work in this type of account? Normally, the first time you use this account will be for the earnest money deposit. The third party will hold this money in escrow for the buyer.
Life of the Mortgage Account:
You might be wondering how does escrow work for the entire life of a mortgage? This account is set up at closing to help the buyer pay for property taxes and homeowners insurance. When a homeowner begins making monthly mortgage payments, a portion of the payment is deposited into escrow. This portion covers expenses outside of the principal and monthly interest on your mortgage. You can think of it like having an extra savings account to pay for taxes and homeowners insurance.
The monthly amount the homeowner pays into this account may change depending on tax increases and higher insurance premiums. Because taxes and insurance costs can change, the lender may choose to require a financial cushion that would cover unexpected costs.
Making sure that property taxes and insurance are paid on time is good for both the homeowner and the lender. Missed payments could result in a tax lien or lapsed insurance coverage and could result in financial penalties for the lender or even foreclosure for the homeowner.
Is an Escrow Account Necessary?
Some lenders will require an escrow account. Usually, this requirement is for risky loans, first-time homebuyers, or if the homebuyer has an Federal Housing Administration (FHA) or U.S. Department of Agriculture (USDA) loan.
However, the requirement of an escrow account is not automatic, so if a home buyer meets certain requirements, he or she could choose to pay for taxes and insurance out of pocket. In addition, if you have a conventional loan, you would need an escrow account unless you can provide more than 20 percent on a down payment. Conventional loans are handled by private lenders and not backed by the government as FHA or USDA loans are. Therefore, the loans have strict financial requirements that not every homebuyer would meet.
What are the Pros and Cons of an Escrow Account?
- Protects buyer, seller, and lender
- Peace of mind that your tax bills and insurance are paid on time
- Easier to budget and manage interest and tax payments
- Higher monthly mortgage payments
- Inconsistent fees if property taxes and insurance premiums fluctuate
- Bad estimates on property value at closing could lead to higher property taxes
Should You Get a Lawyer?
Escrow accounts are common tools that lenders use to provide financial benefits to both buyers and sellers of property. The accounts can help a homeowner ensure financial obligations are met each year without extra effort. Learning the basics of purchasing a home before you take the plunge can be a stressful time. Many deadlines are involved, and escrow can get complicated. That’s why it can be useful to get legal advice to answer the question of how does escrow work? To get started, get online help here.