What is Escrow? A Guide to the Escrow Process

Key takeaways:

• Escrow ensures fairness and security by holding funds or documents with a neutral third party until all transaction terms are met.
  
• There are two main types of escrow: Transaction escrow (during the purchase) and mortgage escrow (after closing).
  
• Escrow accounts simplify ownership costs by combining property taxes and insurance into one predictable monthly payment.
  
• They also reduce risk for both homeowners and lenders by ensuring critical payments are made on time.

As a first-time homebuyer, you may have encountered the term “escrow”, but what does it actually mean? Escrow refers to holding something, like funds or documents, by a neutral third party until all obligations in a transaction are fulfilled. In real estate, “escrow” can refer to two distinct but related concepts:

• Transaction escrow (During home purchase): Protects the buyer’s earnest money deposit and ensures sale conditions are met before funds and ownership are transferred
  
• Mortgage escrow account (Post-purchase): Manages and pays annual property taxes and homeowners insurance in monthly installments
  

Whether you’re buying a home in Albany, NY, or a condo in sunny Scottsdale, AZ, understanding escrow helps make the process less overwhelming. Let’s explore how escrow works and why it matters.

How does escrow work in real estate?

At its core, escrow is a legal arrangement in which a neutral third party holds assets on behalf of other parties who are in the process of completing a transaction. These third parties ensure that both buyer and seller meet the agreed-upon conditions before any money or property changes hands.

During the purchase phase, escrow serves as a safeguard and holds your earnest money deposit, ensuring that neither party is exposed to undue risk as the transaction progresses. Once the sale is finalized, your mortgage lender will typically set up a separate escrow account, this time to manage future property expenses like taxes and homeowners’ insurance. This provides added security and trust for all parties involved.

What is an escrow account?

After you close on a home, your lender opens an escrow account to handle recurring homeownership costs, such as:

• Property taxes
  
• Homeowners insurance
  
• Private mortgage insurance (in some cases)
  

Instead of managing these expenses yourself, you’ll make one monthly payment to your lender that includes your mortgage plus a prorated share of your estimated taxes and insurance. The lender then pays these bills on your behalf when they’re due.

How escrow accounts mitigate risk

Escrow accounts act as a built-in safety system for both homeowners and lenders, ensuring that essential property expenses are handled automatically and on time. This reduces the chance of missed payments, penalties, or financial exposure.

Key ways escrow accounts reduce risk:

• Prevent missed payments: Taxes and insurance are paid on schedule, avoiding late fees or coverage lapses.
  
• Protect lender interests: Ensures property taxes and insurance remain current, safeguarding the lender’s investment.
  
• Reduce homeowner stress: Consolidates multiple large bills into predictable monthly payments.
  
• Minimize human error: Automates critical transactions, reducing the risk of oversight or financial mismanagement.

Why escrow matters in real estate

Imagine you’re buying a home, and the seller agrees to fix a plumbing issue before closing. An escrow agent ensures the repair is completed before releasing any money or property. Without escrow, there’s no neutral enforcement, and in the above-noted situation, the buyer is put at risk.

Escrow also protects the seller, ensuring the buyer’s earnest money is secured and the closing proceeds smoothly. Even for homeowners not looking to buy or sell, escrow ensures critical bills get paid, which protects both the owner and their lender from tax liens or insurance lapses.

The homebuying process involves many moving parts, from inspections and appraisals to final paperwork. Escrow keeps these pieces in sync. By using an escrow agent to hold deposits and documents, both parties are protected from premature or incomplete transfers. In this way, escrow becomes the mechanism that ensures fairness and follow-through.

What is the escrow process?

Escrow begins once the seller accepts an offer. The steps generally look like this:

1. Earnest money deposit

The buyer deposits “good faith” money into escrow. This shows they’re serious and committed.

2. Contingencies and conditions

During escrow, both parties fulfill conditions in the purchase agreement. This may include:

• Inspections
  
• Appraisals
  
• Loan approval
  
• Title search
  
• Repairs
  

3. Escrow duration

Typically, escrow lasts 30-60 days. Delays can occur due to inspection issues, appraisal discrepancies, or financing holdups.

4. Closing

Once all requirements are met:

• Documents are signed
  
• The deed transfers to the buyer
  
• The seller receives payment
  
• The lender sets up the escrow account for ongoing expenses

At closing, you’ll pay escrow fees (generally 1–2% of the home price), initial escrow deposits (3-12 months of taxes and insurance), as well as any other closing costs required. Your lender will provide a loan estimate and later a closing disclosure, which outlines these fees in detail.

The role of escrow in your mortgage

After closing, the lender’s escrow account becomes a regular part of your financial life as a homeowner.

Every month, your mortgage payment now includes not just principal and interest, but also an escrow portion to cover property taxes, insurance, and possibly private mortgage insurance (PMI).

Your lender manages these payments on your behalf. If you miss a payment or let your insurance lapse, the lender can intervene. This could lead to force-placed insurance, which is expensive and offers limited coverage compared to a standard policy.

Benefits of escrow accounts for homebuyers

Escrow accounts can simplify homeownership for many buyers. Here are a few advantages:

• Consistent payments: Escrow acts as a savings plan, spreading out large expenses over manageable monthly payments. Instead of struggling to pay hefty tax bills once or twice a year, you can rely on your lender to handle it promptly.
• Streamlined bill management: Escrow offers a stress-free experience. If your lender makes an error, like missing a payment deadline, they are responsible for rectifying it. This provides peace of mind that your obligations are consistently met.
• Smoother mortgage approval: Many lenders mandate escrow accounts, especially for down payments below 20%. Without one, your loan choices may be restricted, and you might face higher interest rates.

Drawbacks of escrow accounts for homebuyers

Despite the convenience, escrow has its downsides:

• Limited control over funds: One drawback is the lack of investment potential. Money in an escrow account does not accrue interest (except in some states like California). This money could potentially yield higher returns if invested elsewhere.
• Cushion requirement: Another issue is the cushion requirement. Lenders can retain up to two months’ worth of extra funds in your escrow account to cover future cost increases. These additional funds are essentially inaccessible until you sell the property or pay off the loan.
• Payment fluctuations: Escrow accounts may lead to delays in adjustments. For example, if your property taxes decrease, you won’t immediately benefit from the savings. Your lender recalculates escrow balances annually, so any refunds or reduced payments may take months to materialize.

What if you don’t have an escrow account?

If your loan does not include escrow, you are responsible for paying your own taxes and insurance. While this may appeal to homeowners seeking financial control, it also means assuming more responsibility and risk.

If you miss a payment, your lender may establish an escrow account on your behalf, or worse, purchase costly force-placed insurance in your name. These policies are pricier and offer less coverage than standard homeowner insurance.

Even with an existing escrow account, failure to maintain adequate insurance can trigger force-placed coverage. This could occur if your provider cancels coverage or if your lender deems additional protection necessary, such as wildfire or flood insurance.

 

Common Questions about Escrow Accounts

Will your escrow payment change over time?

Yes, even with a fixed-rate mortgage, your escrow amount may fluctuate based on property tax or insurance premium changes. Your lender will review the escrow account annually to adjust for these variations.

Can you get an escrow account if your loan does not include one?

You can usually request an escrow account, but it may require a substantial upfront payment, especially if payments are due soon. This payment can be akin to pre-paying a year’s worth of expenses.

Does your escrow account cover HOA dues?

In some instances, yes, but it is uncommon. Most lenders do not include HOA fees in escrow unless the community mandates it.

How is PMI integrated into escrow?

If your down payment is below 20%, your lender may require PMI. The monthly premium for this insurance is typically included in your escrow payment.

What happens to the escrow account after your mortgage is paid off?

Once your mortgage is paid off or refinanced:

• The escrow account is closed
  
• Any remaining balance is refunded to you
• You will take over direct payment of taxes and insurance