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Escrow is an arrangement where a third party holds money in an account. The deposit towards your down payment is placed in the escrow account until closing. When you own a home, you will most likely have an escrow account.
Buying a home is often the largest transaction a person will ever make and involves large amounts of money changing hands. To ensure everyone receives what they are due, the money transferred from buyer to seller is typically held in an escrow account.
What is escrow? How does escrow work when buying a home? Here's what home buyers and sellers need to know.
What is an Escrow Account? Definition of an Escrow Account
Escrow is a legal process in which a third party holds money or other assets in an account until all parties to a transaction meet certain requirements. These accounts are called “escrow accounts” and you don't have to handle the money. The escrow agent will use the money appropriately.
Escrow process explained
The home buying process usually requires the movement of large sums of money between the buyer and seller, and escrow ensures that everyone will not receive their funds until certain conditions are met.
The main use of an escrow account in this process is to hold the buyer's deposit. When a home purchase contract is signed, the buyer places the deposit in an escrow account. This money protects the seller in case the buyer decides to back out of the deal for reasons not specified in the contract.
If all goes according to plan, the earnest money is paid to the seller at closing as part of the buyer's down payment.
Escrow and Closing
Once the purchase agreement is signed, multiple parties, including the mortgage lender and real estate agent, begin working to prepare the transaction for settlement day, the day you take ownership of the home. This is often referred to as the settlement process.
Escrow is part of this process: your deposit remains in an escrow account until the sale of the home is finalized, at which point it's transferred to the seller.
Types of escrow accounts and how they work
There are two types of escrow accounts: one for use during the home buying process and one for use after the home has been purchased.
1. Escrow Account for Home Purchase
As part of the closing process, you’ll put an earnest money deposit into an escrow account. This amount is typically between 1 percent and 3 percent of the home’s purchase price, or $1,000 to $3,000 for every $100,000.
What if you don't buy the house after all? If you simply changed your mind, the seller probably won't give you your deposit back. If you back out for a reason allowed in the contract, like a low appraisal or a problem with the home inspection, you probably will get your deposit back. An escrow agent can help you sort that out.
2. Escrow Account for Taxes and Insurance
When you get a mortgage, your monthly mortgage payment is made up of a few different parts.
Principal. This is the amount you borrowed initially. Interest. This is the amount the lender charges to lend you the money. You can use a mortgage calculator to find out how much you'll pay each month in principal and interest. Taxes. Homeowners have to pay property taxes, which vary depending on where you live, but are usually paid twice a year. Insurance. Mortgage lenders require you to have homeowners insurance, and depending on the equity value of your home, you may also have to pay mortgage insurance.
Although you are not required to pay taxes and insurance to the lender, the lender has an interest in making sure you pay these expenses, so they will pay them on your behalf through the escrow account.
Your monthly taxes and insurance payments are included in your monthly mortgage payment and are deposited into an escrow account with each payment. Then, when insurance and taxes are due, your lender pays them on your behalf from the funds in the escrow account.
Your lender may require you to keep an extra amount in an escrow account to cover potential increases. They may also require you to put two months' worth of estimated expenses into an escrow account at closing as a cushion. Taxes and insurance costs can change over time. If the lender finds that you were charged too much, they'll refund you. If you underpay, you'll have to cover the balance.
Keep in mind that an escrow account does not hold funds for expenses like utilities or homeowners association dues, as you will have to pay for those services separately.
Do I need an escrow account when taking out a mortgage?
Most types of mortgages require an escrow account for insurance and tax payments, but not all do. Here are the rules for each type of mortgage:
Conventional mortgages: This depends on the lender, the type of loan you're taking out, and the details of your particular situation. If you're a higher-risk borrower (for example, if you put down a small down payment), you may not be able to avoid an escrow account. As your loan payments increase, you may be given the option to eliminate escrow. FHA mortgages: An escrow account is required. VA mortgages: It depends. There is no law that says VA loans require an escrow account, but many VA lenders require one. USDA mortgages: Yes, an escrow account is required.
How long is the mortgage escrow payment period?
Let’s take a closer look at this for both types of escrow accounts.
When you buy a home, your deposit will be held in the escrow account for about a month, which is roughly the same amount of time it takes from when you make an offer to when the purchase and sale of the home is finalized.
As for escrow accounts, where funds for monthly payments are held, it depends on your situation. With a conventional mortgage, you may be able to close the escrow account once the equity in your home has increased enough that you can cancel private mortgage insurance. You can request to cancel PMI once your property is worth 20%, but lenders are legally required to cancel PMI once your property is worth 22%.
You cannot close an escrow account on an FHA or USDA mortgage. For VA mortgages, this may vary by lender.
Some lenders require you to meet certain criteria before they will close your escrow account — for example, you may need to have had your mortgage for at least five years and make all your payments on time.
You may want to close your escrow account so you don’t have to maintain an escrow cushion, but you may also want to keep it open so you don’t have to worry about budgeting for taxes and insurance separately.
What are the escrow fees and costs?
As part of your closing costs, you will pay an escrow fee to the company or party that oversaw the escrow and settlement process. This can be 1% to 2% of the purchase price, depending on the state. This may be paid by the buyer or seller, or split between them.
Escrow is often handled by a title company. Your lender will likely recommend a company to use for your transaction, but you can also shop around for this service and save a little money. Try searching “escrow companies near me” to find real estate escrow services in your area.
Your mortgage may require you to pay a portion of the taxes and insurance fees up front into an escrow account which your lender will use to pay these expenses.
Other Uses of Escrow
Escrow isn't only used in home buying transactions, but that's where people most often encounter it. Whenever a large amount of money or valuable assets are exchanged between two parties, an escrow account can facilitate the transaction in a way that protects everyone. Some services also offer escrow for online transactions to safeguard your funds when buying and selling items online.
What is an Escrow Account? FAQ
When you sign a contract to buy and sell a home, escrow holds funds to be paid to the seller to ensure all of the conditions of the purchase are met. After closing, your lender may set up an escrow account to pay property taxes and insurance premiums as they become due.
An escrow agent is a neutral third party that holds funds in an escrow account until certain conditions are met, then they are either paid to the seller or returned to the buyer, depending on the situation.
No, you cannot withdraw money from your escrow account unless you meet the conditions specified when you created the account. If you stop the sale for a reason permitted by the contract, the money in your escrow account will be returned to you.
To escrow your homeowners insurance, you'll need to talk to your lender or mortgage servicer. Once the account is set up, your lender will calculate how much you'll need to pay each month to cover the full amount of your insurance when it's due.
Laura Grace Tarpley, CEPF
Editor, Personal Finance Review
Molly Grace
Mortgage Reporter
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