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What is Escrow? Breaking it Down in Plain Language

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September 9, 2021

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Escrow is an essential part of homeownership, yet many people find themselves asking, “What is escrow?” Having thousands of dollars moving through a strange account can be stressful if you don’t know all the details.

If you’re someone who’s been facing the same question, it’s important to know exactly why your money may be moved into an escrow account.

What is Escrow?

Escrow is when a third party is granted legal power to hold money or assets until special conditions are met. The purpose of escrow is to reduce the risk for all parties involved in the transaction.

There are two types of escrow accounts you should know about. One you’ll most likely have to use when buying or selling a house, and one that you’ll use while paying your mortgage.

Escrow Accounts for Purchasing a Home

Those buying a house will likely have to put a deposit down to demonstrate they intend to follow through with the purchase. This is known as earnest money or a good faith deposit. Either you or your real estate agent will put this money into an escrow account.

This account works to protect both buyer and seller in the last steps of the transaction. The seller will usually get to keep this good faith deposit if the transaction fails due to the buyer changing their mind. If there are issues from the seller’s end—such as a poor home inspection result—the buyer would get their deposit refunded.

In most cases, buyers get their earnest money back when the purchase is finalized and put it towards their down payment. Buyers get back the amount they put into the escrow account, which is typically 1 to 2% of the overall purchasing price.

In rare cases, money will remain in the account after the purchase—an escrow holdback. The money is not lost, there are just certain conditions that must still be met. For example, if the seller will be staying in the house for a short time after the purchase, the money should be released when they move out.

Escrow Accounts for Insurance and Tax Payments

After closing on your new home, an escrow account will be opened by your lender or mortgage servicer. This is a long-term account, and it will exist for the duration of your loan.

For this type of account, the purpose is to have money set aside for your tax and insurance payments. Your lender will take some of your mortgage payment and put it into this escrow account so that the money can be accessed when tax and insurance payments are due. This ensures your payments will never be late, and that the total amount due won’t be a surprise later in the year.

Tax and insurance accounts benefit the lender as well. If a lien were to be placed on your property due to unfulfilled tax or insurance payments, your lender may have a hard time getting the full loan returned to them. By using an escrow account, your mortgage lender can personally make sure payments are made timely and properly on your behalf. 

When Do You Need to Pay Into Escrow?

For home purchasing, money would go into an escrow account held by a financial institution after the seller accepts your offer.

For tax and insurance, money is automatically portioned off of your mortgage payments and put into the account. By making your monthly payments towards your mortgage, you are providing money that will go into your escrow account. 

The amount due for your mortgage will reflect how much you have to pay towards tax and insurance—usually, 1/12 of each will need to be paid on top of the actual mortgage cost.

What Does Escrow Cover?

Escrow accounts opened for home purchases exist only to hold your initial deposit. This is not extra money that the seller is requiring you to pay, it’s just a portion of the actual cost of the house. By depositing this amount, you are showing you intend to buy their home.

Tax and insurance escrow accounts cover just that—property taxes and home insurance policies. Other types of home-related insurance will also be covered if they’re required where you live, such as flood insurance for at-risk regions. Other bills like water bills are not covered, and neither is homeowner’s association fees nor supplemental taxes.

How are Funds Removed from Escrow?

Since these accounts are holding onto your money, it’s important to know under what circumstances the funds will be accessed. The nature of escrow means that a third party is overseeing the funds you’ve provided, and the removal process is where they’re especially important. Remember that there are conditions on the transfer of the money, so funds usually can’t be moved except under these conditions.

For tax and insurance payments, funds will be taken out of the account to pay the tax and insurance payment themselves when they’re due.

For home purchases, the real estate agent or title company manages the account. They will remove the funds and return them to you at closing, or give them to the seller should you back out of the purchase. In special circumstances, your funds will be returned to you even if your offer is canceled.

Permanently removing funds and canceling an account can be tricky. However, you would start by writing a formal letter request to your lender for account cancellation. Make sure you know the details of your agreement before requesting account closure; you may need to contact your lender for these details before submitting your request.

Learn More About Escrow

Escrow doesn’t have to be complicated or stressful; the legal agreement only exists to protect you and your money. If you’d like to learn more about escrow and what it has to do with your loan, get in touch with the expert team at Associates Home Loan today.

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