What is Escrow and How Does It Affect Me?

Many financial dealings require an escrow agreement. If you ask, “What is escrow, and how does it affect me?” you are in good company. When two parties agree or contract to a financial exchange, they may decide to arrange a third-party, independently-monitored escrow account. The monitor is also known as the “escrow agent.”

The buyer and seller sign the escrow agreement and, once the specific contract terms are fulfilled, the escrow agent releases funds in the manner agreed.

Mortgage Escrow

A mortgage lender may require a home buyer to establish an escrow account for the purposes of paying home insurance and property taxes when they become due. The monthly mortgage payment consists of three parts, including interest, loan principal, and the insurance/tax escrow payment.

Let’s say property tax payments are $4,000 per year and the homeowner insurance policy premiums are $1,500 per year. You must pay $453.33 per month into the escrow account ($4,000 + $1,500=$5,500/12 months = $453.33) to ensure that taxes and insurance bills are paid by the lender as agreed and on time.

Annual Escrow Review

At least once per year, the mortgage lender performs an escrow review to ensure the right amount of funds are allocated to escrow. The lender receives the property tax bills and insurance policy statements, and proper payments are made to the processing institutions even when the escrow bill does not contact enough money to pay them. An escrow shortage occurs and the lender then increases the monthly mortgage payment to recover the money it advanced and prevent any future shortages.

Earnest Money

After you sign a contract to purchase a home or building, you may be asked for “earnest money.” Putting up earnest money demonstrates your commitment to fulfill your commitment. Earnest money offsets the property purchase price when the deal closes.

These earnest funds are placed in escrow until the closing date or as agreed by the buyer and seller. Read the contract carefully to determine if your earnest money is returned in the event the deal does not close.

Home Repair

In some cases, the seller of a property may be asked by the buyer to perform certain repairs or ask the seller for a discount to perform the repairs after closing.

When the property owner hires a contractor to perform the repairs, the parties may agree to place funds in escrow until the repairs are completed. In some cases, a defined percentage of the money is released when a portion of the repairs are completed.

Escrow may also be used when the property owner hires a contractor to complete repairs as part of an insurance claim.

Interest Payments

In June 2013, some lenders became legally required to establish escrow accounts with mortgage loans. Under the law, the lenders must maintain the escrow account for a minimum of five years to assist borrowers in budgeting for the essential costs of insurance and taxes. Otherwise, escrow accounts are arranged at lender’s discretion.

Some refinances, such as streamlined FHA and VA loans, require escrow accounts. Lower down-payment loans, such as those written by Freddie Mac or Fannie Mae, also require escrow accounts.

Other escrow accounts pay interest. Some lenders may allow you to invest money in escrow in an interest-bearing account in lieu of making your tax and homeowner insurance policy payments. Many lenders will waive escrow account requirements for a fee. Other will waive the required escrow account if the homeowner has at least 20 percent equity in the property.

Escrows are a mixed bag, and financial insight about why you must have them in some cases may help you negotiate. Establishing an escrow account may be part of the lender’s requirements to approve the loan or lower the mortgage interest rate. Having the escrow account is helpful to many new homeowners. Budgeting large sums for property and casualty insurance and home taxes can be challenging.

In contrast, borrowers are required to tie up funds in an escrow account sometimes many months before the lender spends it. This fact prevents the borrower from investing the money or earning interest on the funds. A required escrow account limits the borrower’s flexibility in some instances. If the borrower plans to pay taxes and insurance from an annual bonus check but must pay these bills on a monthly basis, paying into the escrow account can make paying other bills more difficult.