What is an Escrow?
An Escrow account is an arrangement where a third party holds funds from a buyer and seller during the process of sales transaction. The account has various uses anywhere from online purchases to home buying, the most common use is to ensure fair real estate agreements. The buyer wants to guarantee that the asset being purchased is the quality they expect and the seller want to guarantee that the payment for the asset, once value is proven, is received on time. This is why a third party is used, in order to protect both parties and ensure fair deals. They will hold the cash from the buyer and the property papers from the seller during the sales process. Once they have reached an agreement, the escrow provider will disperse the cash and close the escrow account.
Types of Escrow Accounts
To protect the buyer from hidden property damages and the seller from uncommitted buyers. Typically there is an initial payment called earnest money which is to show the seller you are seriously considering the purchase of their property, sort of like a deposit. It is usually an amount of 1-3 percent of the property value.
This is when the escrow account is set up which holds that earnest money and the property deed. If the deal falls through, typically the buyer will receive back the earnest money. Rarely will the earnest money go to the seller because of a dead deal, which would have to be the fault of the buyer. If the deal goes through, that earnest money will be used towards the down payment.
To ensure annual property taxes and homeowners insurance payments being made, in a monthly format bundled with homeowners mortgage payment.
After the home closes and the buyer officially owns the home, the mortgage lender can open an escrow account to pay for the homeowners property taxes and insurance. This account is funded through a homeowners monthly mortgage payments made to the lender. Once received, the lender will take a portion of that mortgage payment and put it in the escrow account to pay for taxes and insurance. Property taxes are paid three to four times a year, and insurance is usually paid annually.
The breakdown of the mortgage payment is called PITI, which stands for Principal, Interest, Taxes, Insurance. Since the amounts for taxes and insurance can change each year, the lender will estimate the escrow payments added to the monthly mortgage a year out, based on the previous year. After each year, the servicer from that lender will take a look at the escrow account to make sure there wasn’t a surplus or deficit of your funds. With a surplus, they will issue a refund. Less likely to happen, a deficit will require the homeowner to pay the remaining balance. This can usually be done through an increase in the amount of their monthly mortgage payment that funds the escrow account.
Are Escrow Accounts Required?
You do not need to have an escrow account to pay for property taxes and insurance, if you are using a conventional loan. Choosing to pay for each yourself would mean just coming up with the large payments for each instead of having portions rolled into your monthly mortgage payment. Again, property taxes are paid every three to four months and insurance is usually an annual cost.
If going with a government loan (FHA, USDA, VA), it is required to have an escrow account.