What is escrow? How does it work with a mortgage?
Whether you’re a first-time homebuyer or a veteran of the homebuying process, the world of home mortgages with its unfamiliar terminology and complicated processes can be both confusing and overwhelming. For many, escrow is one of the trickiest concepts to tackle. While most people have a general idea about what escrow might mean, few seem familiar with the specifics and why this critically important process can make or break their homebuying experience. Let’s demystify the escrow transaction and answer a few key questions along the way.
What does escrow mean? Why do I need it?
Escrow simply translates to a financial arrangement. This arrangement is used in many industries and situations, but you may be most familiar with its common use in residential real estate. When a potential homebuyer approaches the financial transaction of purchasing real estate, it makes sense that both the buyer and seller would want a sense of security about the process. After all, this is a major transaction usually figuring in the hundreds of thousands, and all parties want to feel good about making the deal.
In an escrow arrangement, an objective and unaffiliated third party will hold the funds necessary for the transaction, releasing them only when both the buyer’s and seller’s terms are met. This third party might be an escrow company or agent, a title agent, or a closing attorney. The third party remains neutral, and has nothing to lose or gain from the transaction (other than a small fee amounting to about 1-2% of the home’s purchase price, which can be paid by the buyer, the seller, or split between both). An escrow may also be referred to as an “impound,” or keeping your funds in “reserves.” All these terms typically mean the same thing.
While your funds being held in mortgage escrow can test your patience and keep the homebuying process in a kind of limbo, it’s critical to engage in the escrow process in order to protect your interests, along with the interests of the seller. An escrow provides security while you undertake the negotiation and agreement process.
What can I expect from the mortgage escrow process?
Now that you understand the basics, let’s go over the step-by-step escrow process. Being prepared for the specifics of the escrow can make the whole endeavor run as smoothly as possible.
As an initial step, either you or the home seller will need to identify the right escrow company or agent. To do so, we recommend identifying several local options and asking them a series of questions to learn about the flexibility and efficiency of their practices and services. Here are a few sample questions:
- What are your typical escrow fees, including potentially hidden charges for delivery, recording, wire transfers, etc.?
- Are you able to meet a client for a signing outside your office?
- Do you have a mobile notary available?
- What services differentiate you from other local escrow agents and companies?
Once you’ve selected an escrow agent:
- A signed agreement — detailing all the required terms from both home buyer and seller — is delivered to the escrow agent/company.
- As the buyer, you will write a check to the escrow agent for an earnest money deposit (which will ultimately be applied to the home’s purchase price).
- The escrow agent will ensure that all stipulations in the agreement are met (i.e. home inspections occur on time), and will penalize the parties that do not uphold their end of the bargain.
- During the escrow, any necessary mortgage, homeowner’s insurance, or property tax payments are paid by the escrow agent to the appropriate parties, using the escrow account.
- Escrow closes when the agreement terms are met and home ownership transfers to the buyer.
This standard mortgage escrow process helps to ensure that all parties meet the obligations outlined in their agreement, while simultaneously protecting the funds needed for the transaction to be completed.
The escrow process, along with the rest of the homebuying experience, doesn’t need to cause headaches. We hope we’ve provided you with more clarity on the concept and uses of escrow in residential real estate and mortgage transactions and you feel ready and confident in your homebuying journey.
What about other aspects of homebuying, like down payment or loan types? Check out our Homebuying 101 guide.