What Does Escrow Mean In Real Estate And How Does It Work?

For many people, the home buying process is their formal introduction to real estate and mortgage-related jargon. One of the terms you’re likely to hear on repeat is “escrow.” Your real estate agent or lender may talk about earnest money or a house going into escrow, but what does escrow actually mean?

If you plan on buying a home, you should understand what escrow is in real estate, how it works and how it affects you.

What Does Escrow Mean?

Escrow is a legal arrangement in which a neutral third party holds funds until a particular condition(s) has been met. The funds are disbursed to the intended recipient once the condition or contingency has been fulfilled. Escrow protects both buyers and sellers in the home buying process.

Escrow has several uses in real estate transactions. It’s typically used to hold on to a buyer’s earnest money until the purchase agreement is finalized.

The seller is protected because they know the money was deposited in a safe place. And the buyer knows that if they need to back out of the sale for a reason allowed under the terms of the purchase agreement, they won’t have to worry about getting their money back from the seller.

Escrow may not always close once the sale is complete. The account may be used to hold a homeowner's property insurance and taxes throughout the year.

What Is An Escrow Account?

An escrow account is the location where the funds get deposited. Think of an escrow account like a bank account – it’s a safe place to put money until you’re ready to use it. There are generally two types of escrow accounts in real estate. And we discuss them further below.

Escrow Accounts For Home Sales

Escrow accounts for home sales protects a buyer’s good faith deposit or earnest money. When you put an earnest money deposit toward your purchase, it signals to the seller that you’re serious about buying the home.

The seller keeps the money if you don’t follow through with the purchase. If you move forward with the purchase, the earnest money will go toward the purchase price at closing. Generally, earnest money gets applied to your closing costs or down payment.

The escrow account protects both the buyer and the seller. The seller feels protected because they know the earnest money has been paid. And the seller will likely get the money even if the buyer walks away from the sale.

The escrow account protects the buyer by ensuring the seller doesn't get the money until the sale is finalized. If contingencies aren’t met, buyers can back out of a sale and get their earnest money back based on the terms of the contract. Because the money is in escrow, the buyer can trust they’ll get their money.

Escrow Accounts For Homeowner Fees

Escrow accounts are also used after a home purchase. When you make monthly mortgage payments to your lender, the payments cover the principal and interest and usually include property taxes and homeowners insurance premiums.

Taxes and insurance are paid once or twice a year. The money you pay for taxes and insurance goes into your escrow account each month. Then the escrow company pays the appropriate parties when the bills are due.

Who Manages Escrow Accounts?

Escrow accounts are managed by a neutral third party – not the payer (the depositor) or the payee (the recipient) of the funds. Who manages the account will depend on the type of escrow account it is. If the third party is holding on to earnest money, it’s likely a title company. If the account holds your property taxes and homeowners insurance, it’s likely a lender or loan servicer.

Escrow Companies

The escrow account may be managed by an escrow company that analyzes the account each year. If the escrow account holds earnest money, the buyer and the seller both share the cost of account management. In this case, the escrow company would typically be a title company or a real estate attorney.

Mortgage Servicers

A mortgage lender would usually manage an escrow account that holds property taxes and homeowners insurance. Your lender will set aside a portion of your monthly mortgage payment and deposit it in the escrow account to pay your taxes and insurance when they’re due.

Your mortgage lender typically manages your escrow account as long as you have a home loan with them. Once the mortgage is paid off, you stop making payments to your lender. At that point, it may become your responsibility to pay those bills directly each year, or you can set up a new escrow account to serve the same function.

How To Choose An Escrow Provider

As a home buyer, you’re usually in charge of deciding who to use for escrow. It usually can’t be your real estate agent or the seller’s agent. A seller or agent can recommend escrow providers, but the buyer has the final word.

When choosing a provider, here are the most important factors to consider:

• The escrow agent’s experience
• The financial stability of the escrow company
• The cost of escrow services

The Pros And Cons Of Escrow

Escrow is a routine part of the home buying experience, but it has pros and cons. If you plan on buying a home, you should understand how escrow may affect you.

Pros

• Escrow offers protection: The primary benefit of escrow is that it protects the buyer in case they need to back out of the deal, and it protects the seller if the buyer backs out without cause.
• Lenders make the payments: The lender makes the payments when the escrow account is set up for your property taxes and insurance. You’ll likely never find yourself frantically pooling enough money to cover your property tax or homeowners insurance payment when it’s due.
• Payments made on time: When the lender handles payments for your taxes and insurance, you can rest assured the money is there, and the payments arrive on time.

Cons

• Buyers may experience an escrow shortage: The amount needed for your taxes and insurance is an estimate. That means one day you may find yourself in a situation where your taxes or insurance have gone up, and when the time comes to pay either bill, there isn’t enough money in the escrow account to cover it. In that scenario, you’d need to produce the additional amount.
• You may have higher mortgage payments: If you have an escrow account, your mortgage payment is made up of principal, interest and the taxes and insurance that get deposited into the escrow account. If you didn’t include escrow in your calculation, your mortgage payments may be higher than you initially anticipated.
• Your money is tied up: You can’t touch your money once it’s deposited into the escrow account. You’re tying up your money for an entire year, and there’s always a risk that you may overpay into the account. Any extra money will be reimbursed, but that’s money you might have used for something else.
• Large upfront payments: Mortgage lenders often require an upfront payment equal to several months’ worth of property taxes and homeowners insurance to establish the account. The payment is due at the closing along with your other closing costs and fees.

Escrow Example

Let’s run through an example. Say you’re shopping for a new home and finally find one priced at $300,000. You offer 3% earnest money, which is $9,000. The money goes into an escrow account until you close. When the sale is finalized, you apply the $9,000 to your down payment.

After closing on the home, you enter into another escrow account with your lender. Each month, part of your monthly payment is set aside for taxes and insurance and placed in an escrow account. When the payments are due, your lender withdraws money from the account to pay your property taxes and homeowners insurance.

If you didn’t have an escrow account, your monthly mortgage payment would be $1,000, which would only go toward paying down your principal and interest. Your lender estimates you’ll owe $6,000 in property taxes and insurance for the coming year. With 12 months until payment is due, $500 would go into escrow each month ($6,000 / 12 = $500). With escrow, your monthly mortgage payment would be $1,500 per month.

Escrow Meaning: FAQs

There’s still a lot to learn about escrow’s meaning and how it works for home buyers. Read through some frequently asked questions about escrow.

What does it mean when a house is in escrow?  

When a house is in escrow, it means there are still funds in an escrow account, and legal ownership hasn’t been transferred. The house will remain in escrow until all conditions are satisfied and the sale is finalized.

How do you remove escrow from your mortgage?

Many lenders require escrow while there’s a mortgage on your home. Once you’ve paid off your loan, you can remove escrow. Some lenders may allow you to remove escrow before paying off your mortgage under certain conditions. Just know that if you remove escrow from your mortgage, you’ll be on the hook for your tax and insurance payments.

How much does escrow cost?

Escrow fees typically cost 1% – 2% of a home’s purchase price. If you buy a $300,000 house, you’ll likely pay $3,000 – $6,000 in escrow fees. If escrow is set up for your taxes and insurance, the fee will depend on where you live and the homeowners insurance you buy.

What is an escrow disbursement?

An escrow disbursement is a payment made from an escrow account. It’s usually used to pay property taxes and homeowners insurance and usually comes from a lender on behalf of a homeowner.

What do escrow accounts not cover?

Escrow accounts usually cover your property taxes and homeowners insurance – and that’s it. Other expenses, including HOA fees, home utility bills and other payments, are your responsibility.

What is an escrow holdback?

An escrow holdback is when additional funds are collected at closing to address any repairs or improvements to a property. Depending on the agreement, the buyer or the seller can pay the funds. But, in most cases, it’s the seller. The money is refunded once the buyer or seller fixes the pending issue(s).

The Bottom Line

Escrow, which protects the buyer and seller, is an important step when buying a home and is often a necessary part of taking out a mortgage. You’ll encounter two types of escrow accounts at different points of the home buying process. One you’ll encounter during the purchase phase, and the other after the sale is finalized.

If you’re getting ready to buy a home, start the mortgage process today.