An escrow is a legal arrangement describing a financial instrument in which a third party holds an asset or escrow money on behalf of two other parties that are in the process of completing a transaction.
Escrow accounts may include escrow fees managed by agents who hold the assets or money until the contractual obligations are fulfilled or until receiving further instructions. Funds, securities, and other assets can all be held in escrow, but how does escrow work in real estate, and what are its benefits? Find out here.
What Is Escrow in Real Estate?
As we mentioned, an escrow is a legal arrangement in which a third party holds money or assets on behalf of two other parties until a specific condition has been met. In real estate transactions, it’s used to protect both the seller and the buyer throughout the home buying process. In terms of the mortgage, an escrow account will hold funds for homeowner insurance and taxes.
Escrow in real estate is typically used to protect the buyer’s good faith deposit so that the right party receives the money according to the conditions of the sale. It’s also used to hold a homeowner’s funds for homeowners insurance and property taxes.
Here, we’ll be discussing the pros of using escrow in real estate. However, they all hinge on getting professional services. And there’s a big difference between hiring an escrow agency that just started and one with a proven track record, such as Lightspeed Escrow.
Escrow For Home Buyers
The good faith deposit shows that you’re serious about buying the home, and your purchase agreement will often include this deposit. If the home purchase is successful, the deposit will be applied to your down payment. And if the contract fails due to your fault, the seller typically keeps the money.
An escrow account will be set up to hold the deposit to protect both the buyer and the seller, and the good faith deposit will sit in it until the translation closes. After that, the money will be applied to your down payment.
In some cases, an escrow holdback may be needed. The escrow holdback is when funds stay in escrow after the sale of the property completes. There are various reasons an escrow holdback may be necessary. For example, you found something wrong with the property during the final walkthrough, or you agreed that the seller stays in the home one more month. And once the conditions are met, the funds will be released to the right party.
Escrow For Taxes And Insurance
After you buy a home, your lender will set up an escrow account to pay for your insurance and taxes. Then, after closing, your mortgage servicer takes a portion of your monthly mortgage payment and keeps it in the escrow account until your insurance and tax payments are due.
The amount required for escrow is a moving target, and your insurance premiums and tax bill may change annually. Your mortgage servicer will determine your escrow payments for the following year based on the bills paid the year before. Most lenders demand a minimum of two months’ worth of additional payments to be held in your escrow account.
Your servicer or lender will analyze your escrow account annually to ensure they’re collecting just enough, not too little, and not too much. If they determine they’ve collected too much, they’ll give you an escrow refund. On the other hand, if their analysis shows they’ve collected too little, you’ll have to cover the difference.
The Advantages of Using Escrow in Real Estate
The most significant advantage of using escrow in real estate is that you’ll be protected during a transaction, whether you’re the buyer or the homeowner. Escrow can benefit lenders, too. Read on to discover the perks of using escrow in real estate.
An escrow account is critical to protecting your deposit. For instance, if you’d given your deposit directly to the seller, he may not return your deposit if the sale falls through because of an issue found during the inspection. However, when the third party holds the deposit, you can rest assured it will be returned to you according to the agreement.
If you’re a homeowner, you can benefit from using an escrow account as you won’t have to come up with a lump sum to cover insurance and taxes. You’re paying for your taxes and insurance throughout the year. Therefore, the payments are easier to handle.
Another advantage is that you won’t have to keep track of the different due dates as your mortgage servicer will ensure the bills are paid on time. He will even cover bills if your escrow account is short on funds.
Lenders have a vested interest in ensuring your property taxes are paid because if your tax bills don’t get paid, the tax authority could put a lien on your home. This could cost the lender more if the tax authority chooses to foreclose.
They also have an interest in making sure your insurance gets paid because if your homeowner’s insurance coverage fails, considerable damage to or loss of the house may lead to the significant loss of the home’s value.
That said, having an escrow account allows the lender to make sure the bills are paid.
Things to Consider
Escrow accounts don’t cover all the expenses associated with homeownership, such as utility bills and HOA fees. Escrow accounts also don’t cover supplemental tax bills as these are one-time bills issued due to new construction or a change in ownership. And your lender won’t be able to predict when you’ll get a supplemental tax bill and how much it will be.
So, Do You Need An Escrow Account?
You may be able to pay for property taxes and insurance on your own, and doing so will lower your monthly mortgage payment. However, you’ll have to save for tax and insurance yourself.
Note that not everyone can opt-out of an escrow account as they are required on certain loans, such as FHA loans. For VA loans, you’ll need a strong credit profile and a 10% down payment if you want to opt-out of an escrow account. For conventional loans, you’ll at least a 20% down payment.
However, you may be able to use an escrow account for some costs and not others. In some cases, lenders require escrow for taxes but not insurance.
Using Escrow in Real Estate Protects Both Buyers And Sellers
Escrow protects both buyer and seller throughout the home selling process. It also offers a convenient way to pay for your insurance and taxes.
Whether an escrow account is required or not will depend on the type of the loan and your financial profile. Although it may be tempting to bypass it due to lower monthly mortgage payments, using an escrow account will ensure all the bills are paid on time. And that’s just one of its benefits.