What is escrow and how does it work?

In a nutshell

Escrow is a financial arrangement where a third party holds and manages the movement of payments between two or more parties.

• Escrow services are used in transactions where all conditions of an agreement are met before funds are released to the person or entity.
• The goal of escrow is to reduce the risk of fraud with a neutral intermediary (e.g. an escrow service or account) holding the buyer's payment until the seller has fulfilled their obligations.
• It serves to protect both parties involved in a transaction with large amounts of money in a high-value purchase.

How does escrow work?

The main features of escrow are designed to bring fairness and security to high-value transactions, such as property deals, online purchases, or large contractual agreements. More specifically, an escrow service may be used for a big construction project or a consulting engagement. An escrow service may also help with big-ticket items purchased online or between private parties, like the sale of a boat or mobile home.

First, escrow services ensure that the terms of an agreement are fulfilled before releasing funds in a transaction. This way, buyers and sellers have some assurance that funds will be disbursed and goods received without problems.

Then, escrow services offer dispute resolution mechanisms. In case of any disagreements or concerns around a transaction, the escrow service can mediate and resolve issues based on the agreed contractual terms.

How is escrow used in real estate?

Property purchases

When a property goes under contract in a real estate purchase transaction, the buyer is asked to give the seller a good-faith deposit, also known as an earnest money deposit (EMD). Instead of giving this money to the seller, who could run off with it, the funds are placed in escrow until the sale is completed. The EMD is usually credited to the transaction to cover the buyer’s closing costs, such as the down payment and fees.

If for some reason the transaction doesn’t get to the closing table, the EMD may be refunded to the buyer (provided the cancellation reason meets the terms of the purchase contract). If the cancellation isn’t done according to the contract, the seller could keep the buyer's deposit. In the event the buyer and seller can’t agree on who gets the deposit, the escrow agent may defer the case to a court to decide how to allocate it.

Mortgage loan servicing

Another common use case for escrow is when borrowers pay their monthly mortgage payment to a loan servicer. The servicer will set aside funds from the mortgage payments in an escrow account to cover property taxes, homeowners insurance, and possibly private mortgage insurance (PMI). Holding funds for these expenses in escrow reduces the risks of liens against the property and potential losses for both the homeowner and the bank if these expenses go unpaid.

The amount in a borrower’s escrow account can change from year to year as insurance premiums and property taxes change. Mortgage servicers typically review escrow accounts annually to make sure there’s enough to cover the expected disbursements.

If there is a shortage in the escrow account, the lender may adjust the escrow payments upward. If there’s extra, the money can be refunded to the homeowner or applied to the loan’s principal. Borrowers should receive an escrow analysis each year so they can understand and scrutinize, if needed, the movement of money in and out of this account.

Who manages an escrow account?

Escrow accounts are managed by an escrow agent. This agent is typically a neutral third-party entity with no vested interest in the transaction. An escrow agent could be a law firm, title company, real estate brokerage, bank, or even an online escrow company.

In the case of a mortgage escrow account, the loan servicer also provides escrow services. The servicer will manage escrow funds and payments on behalf of the mortgage company and the buyer.

Escrow account pros and cons

When should you get an escrow account?

Buying real estate

You should use an escrow agent when dealing with a seller or lender you don't personally know or trust. The escrow agent ensures all agreed conditions are fulfilled before transferring the funds, which can make a transaction less risky. In most real estate transactions, the use of escrow is a standard practice because it’s a process that has been proven to protect both buyers and sellers.

Paying your mortgage, insurance, and taxes

Using escrow as you make mortgage payments can help you manage extra expenses beyond your principal and interest payments. Some homeowners might find it overwhelming to save for, manage, and make lump sum payments for property taxes and homeowners insurance. The escrow account allows these large payments to be broken down into monthly payments to help borrowers spread these expenses throughout the year.

Frequently asked questions (FAQs)

How long do I pay escrow on my mortgage?

Your mortgage lender will require you to maintain enough funds in your escrow so that your property taxes and insurance are paid on time. In some cases, your lender may waive the escrow requirement once you reach enough equity in your home.

Is escrow good or bad?

For most homebuyers and borrowers, using an escrow service for purchasing a home and making mortgage payments is helpful and can help reduce the risk of bad financial outcomes.

Do you get escrow money back?

When buying a home, you can get your earnest money deposit (EMD) in an escrow account back if the purchase contract is canceled according to the contract terms.

Can I remove escrow from my mortgage?

Yes, in some cases, your lender may waive the requirement to keep your property taxes and insurance payments in an escrow account. This typically happens when you reach a certain amount of equity in your property, which may vary by lender.