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What Does Escrow Mean and How Does it Work?

May 27, 2020

6 MINUTE READ

what does escrow mean

Escrow is one of those things that most people have heard of, but yet many still don’t know exactly what escrow means or how it works. When you take out a home loan, the chances are good that your lender will require an escrow account. You’ve probably heard this term before. In fact, you may even know that in most situations, an escrow account is an account reserved for money that your lender will use in order to pay your property taxes and make your homeowner’s insurance payments. 

Even so, you may not understand exactly how these accounts work, how money gets moved into them, or even why lenders require them. After all, many buyers have questions about escrow accounts. When you buy a new home, you may likely have to open or establish two different accounts: one before the purchase of your home is finalized and one after your mortgage loan closes. 

Fortunately, we’re here to help eliminate any confusion. Let’s take a closer look at what escrow is and how it works, as well as how it can benefit you as a home buyer. 

What does escrow mean?

To put it simply, escrow is a legal arrangement in which a 3rd party will temporarily hold a large sum of money or property until a certain condition or conditions have been met, such as the fulfillment of a purchase agreement. 

When you close on a mortgage, your lender will likely establish a mortgage escrow account, an account where part of your monthly mortgage loan payment is funneled to cover some of the other costs of owning a home, such as insurance premiums, private mortgage insurance (if necessary), real estate taxes, and more. An escrow account helps to ensure that your payments are made on time to any third parties, such as insurance companies or county tax offices.

How does the escrow account work? 

In order to set up a mortgage escrow account on your behalf, your lender will figure your annual payments for taxes and insurance and then divide that amount by twelve, to get a monthly total. This amount is then added to your monthly mortgage statement. Then, your lender will deposit the escrow portion of your mortgage payment into your escrow account each month and will pay your insurance premiums and real estate taxes when they come due. 

Keep in mind that, depending on where you live, your lender may require an escrow cushion, as allowed by certain state laws. This cushion is designed to cover any unanticipated or unforeseen costs, such as an increase in your taxes. If the estimated amount in your escrow cushion turns out to be more than you, the difference will then be credited or refunded to you. 

Should you set up your own escrow bank account? 

This is a question that we hear often, and the best answer we can give is this: it depends. Before you roll your eyes, hear us out. The answer to this question depends on how disciplined you are with your finances and the ability to set aside the funds you will need for insurance payments and property taxes. 

If you are not a good saver or tend to spend any money you have left over, it is probably a good idea to let your lender handle these payments for you — especially given that late or missed payments can result in a host of negative consequences, such as penalty charges, a lapse in coverage in your insurance, or even a lien being placed on your house. 

However, if you are disciplined in your finances, you may actually prefer to control the process yourself, especially considering that these payments are typically only due once or twice a year. 

Awaiting the bank’s appraisal

The bank that is handling your mortgage will then do its own appraisal (typically the responsibility of the buyer) to protect its financial investment, should there ever come a need to foreclose on the property. 

And keep in mind that if the appraisal amount comes back lower than the price you offered for the home, the bank will not extend financing to you, until you have come up with the difference in prices, or the seller agrees to lower the price to the appraised amount of the home. 

Of course, you can always appeal and try to reason with the appraiser using one of the following tactics: 

  • You could provide any additional information you have about why you think the home should be appraised at a higher price point
  • You can pay for a second appraisal using a new appraiser
  • If all else fails, you can try another lender and hope that the appraisal your new lender does comes out in your favor 

Unfortunately, if none of these options are possible or none of them work, you may have to cancel the purchase contract. 

Escrow accounts for buying a home

When you are buying a home, the purchase agreement will typically include a deposit made in good faith, or earnest money. The purpose of this money is to demonstrate that you are serious about purchasing the home. If the contract falls through for any fault of yours (as the buyer), the seller gets to keep the earnest money. And if the purchase goes through, your earnest money then goes toward your down payment. 

In order to protect all parties, an escrow account is set up to hold the deposit. Your good faith deposit then sits in this account until the transaction is finalized. Once the purchase is complete, the funds are then applied toward your down payment. 

Sometimes, these funds are held in escrow even after the completion of the sale. When this happens, it is known as an escrow holdback — and there are many reasons it may be necessary. Maybe you agreed to let the seller stay in the house an additional month or two until their new home is ready. Or, perhaps you found something that needs to be repaired during the final walkthrough. If you are building new construction, the money can remain in escrow until you’ve done a final sign off on all of the work. Whatever the case may be, once all of the conditions have been met, the money that is in escrow is then released to the proper party. 

What isn’t covered by escrow accounts?

Of course, escrow accounts don’t cover all of the traditional expenses related to owning a home. For example, your lender will not collect money to pay your HOA dues or utility bills on your behalf. Supplemental tax bills are also not covered by escrow funds. 

Since these are one-time tax bills issued as a result of new construction or a change in ownership, your lender isn’t able to predict when you will get one of these tax bills — or how much it will cost. 

Understanding escrow with Reali

If you’re in the market to buy a home but have questions, you don’t have to go it alone. At Reali, we are proud to offer a home buying process that you can trust. We help you find your perfect home at the best price, with the help of our experienced, local agents. 

Read for yourself what our clients have to say about working with us and what makes us different. Contact us when you’re ready to get started!

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