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Escrow account and it's significance

Updated: Apr 24, 2022

What is an Escrow?

An escrow is a financial agreement where a third party holds the money temporarily and controls the transfer of money from one party to another until certain conditions are met by both the parties involved in the process. The third party may hold money, assets, securities or paperwork on behalf of one of the party involved. When it comes to real estate, Escrow can be used during the home buying process or during the life of the mortgage loan by holding the homeowner's property tax and insurance.

What is an Escrow account?

Escrow account in home buying process

When you are buying a home, the purchase agreement might usually include the Earnest money. Earnest money is typically 1-2% of the purchase price of the home which is paid by the buyer in advance to show how serious are they to buy the home. This amount is kept in hold by the third party in an escrow account. If for any reason the contract falls through because of the buyer's fault after the specified option period, then the seller usually gets to keep the earnest money. If the contract goes through successfully, the earnest money paid by the buyer is reduced from the down payment of the loan.

Escrow holdback is a process where the escrow funds are put on hold even after the completion of the sale of the home. This occurs in situations like where the buyer has agreed for the seller to stay a little longer after the completion of the sale of the home or the buyer has found something wrong with the property during the final walk through before the sale of the home.

Escrow account in the life of the mortgage loan

After purchasing a home, there is an option to open an escrow account with the lender where the lender keeps a portion of mortgage payment aside for the Property taxes and Insurance until it becomes due. The property tax and insurance varies from year to year, so the lender usually collects an extra of two months of payments to keep up the cash flow. By any chance, if the lender feels they collected too much, they refund the extra money. If the lender feels the money collected is too little, then they may give the buyer an option of either to pay in full or to add a little in the buyer's monthly installments.

Advantages of Mortgage Escrow account

Some lenders may provide a discount or lower interest rate if the buyer decides to open an escrow account for the property tax and insurance premium payment. We usually don't have to worry about the payment of lump sum for the property tax and insurance and there is no need to set aside and budget for the tax and insurance as the lender does this automatically. This is also called as an Impound account. It establishes a structured way of payment as it spreads out the cost evenly throughout the year.

How does it work in home buying process?

  • The escrow process starts from the preapproval and offer acceptance. Once the buyer and seller agree on the purchase price and purchase contract is signed, the escrow process is started.

  • An Escrow account is opened and the buyer deposits the Earnest money to show the seriousness of the offer by the buyer.

  • Then the lender starts the appraisal process to know the value of the home and to secure the lender's interest on the loan. If the appraisal amount comes out less than anticipated, the lender might not provide loan to the buyer unless the buyer comes up with the difference or the seller lowers the price.

  • Once the appraisal process is done successfully, the lender might give a loan estimate with the terms of the loan such as mortgage amount, interest rate, closing costs etc. Once the loan commitment is received, the financial contingency may be removed if the buyer had one.

  • Then, the buyer usually receives the Seller's disclosure which usually discloses all the known problems of the house by the seller and the seller's agent. The buyer may also order a home inspection where the home is inspected by a professional home inspector to look out for any defects on the home that is present currently or that might occur in future.

Escrow account and it's significance
Escrow account and it's significance

  • If the inspector finds out any major defects on the home, the buyer has the option to either walk out of the contract, negotiate for the repairs or ask the buyer to reduce the purchase price of the home. If the inspection goes well, Inspection contingency is removed from the contract.

  • Purchase Homeowner's insurance, Hazards insurance like Earthquake insurance or Flood insurance is needed for the places that are prone to specific hazards.

  • Then, the lender usually asks the buyer to buy Title Insurance called as the Lender's Policy to protect the finances of the mortgage lender against any claims on the property. The lender's policy is usually effective through the life of the loan.

  • If there is anything wrong on the title or cloud on the title, then the seller needs to clear the title before the closing of the home.

  • The buyer may make a final walk through before officially closing the deal and a closing disclosure is sent to the buyer at least 3 days before the closing breaking down the closing costs, mortgage terms, APR, penalties etc.

  • Once the closing process is done and all the paperwork has been signed by both the buyers and sellers, the escrow officer usually prepares a new deed and the new ownership is recorded in the county recorder. The money is paid either by a cashier's check or transferred through wire.

  • The fund is directed to the escrow and the escrow directs it to the seller or the seller's lender and the escrow is closed.

Is opening an Escrow account / Impound account mandatory?

Opening an escrow account is not mandatory if the lender doesn't specify. It depends on the type of the lender and their terms. Especially in loans like FHA, VA, conventional loans with small down payments, the lenders usually ask the buyers to open an escrow account to make sure their property tax and insurance are properly budgeted to be paid. Some lenders may also look at the credit score and credit history. If the score is considerably low, the lender might want the buyer to open an escrow account to pay the tax and insurance on time.

What happens when you don't have an Escrow?

If you choose to go without an escrow option, it is very important to budget the monthly savings for the property tax and insurance. Failure to pay the property tax may result in a lien placed on your home or even foreclosure. In the event of failure to pay for an insurance policy, the lender may take an insurance policy on your behalf and you might be responsible to pay for it. There are chances the insurance policy taken by the lender might be more expensive than the policy that you shopped for yourself.

What happens to the escrow account while selling the home?

If a person decides to sell their home, all the extra money in their escrow account might be refunded within 20 business days, depending on the lender, there might also be an option to forward the old escrow money to the new escrow account if the person decides to buy a new home.

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