Out of all the unfamiliar terms you’ll need to understand as you move through the mortgage process, escrow might be the most foreign-sounding. Thankfully, this strange term really isn’t all that complicated and is actually immensely helpful as you work to finalize the deal on your home.
What is escrow?
Escrow is a general financial term that most of us encounter in the homebuying process. However, it’s a concept that’s utilized in all kinds of transactions, usually when a large amount of money will be changing hands. Essentially, escrow describes a contractual arrangement between a buyer and a seller to hold the money used in a purchase in an intermediate account. This escrow account is controlled by a neutral third party who agrees to only transfer that money from buyer to seller when each has met all contractual obligations.
It’s easy to see why this might be useful as buyers and sellers negotiate on a home purchase. When making an offer on a home, the buyer is expected to deposit an earnest money check into escrow and then hash out the details of the deal. While it’s in escrow, neither the buyer nor the seller can touch it until the third party (the “escrow officer”) certifies that the purchase contract has been fulfilled.
An escrow account will be officially closed once the third party has received confirmation from both the buyer and seller that all contractual obligations have been met. Usually, some money can be held in the escrow account to cover specific line items of the purchase contract that haven’t yet been completed. For example, if the seller agreed to make a repair to the home in the contract, the funds for the home itself may be transferred out of escrow, minus the expense of paying for that repair.
Escrow and your lender
The other common use of escrow is related to how you make regular mortgage payments after the purchase is completed. In many cases, mortgages will include terms for an escrow account that is used to pay homeowners insurance premiums and property taxes. These accounts are sometimes called “impound” or “reserve” accounts, but the concept is the same.
Why do lenders require an escrow account as you pay your mortgage? It may seem like an extra hassle, but it’s done to reduce risk for everyone involved. When you use a mortgage to buy a home and begin paying it off, your lender technically owns a portion of the home equivalent to the amount of principal that you haven’t yet paid for. That means if your home was destroyed without insurance, or if you neglected to pay your property taxes, both you and the lender would be financially responsible.
By designating an escrow fund for these mandatory expenses, it does more than streamline monthly payments. It also helps homeowners make sure that money is being spent appropriately, since the account is controlled by a neutral third party. It might seem like extra work, but these accounts actually reduce the number of bills you need to worry about every month.