7 Min Read | Published: April 12, 2024
What Is Escrow and How It Works?
Explore the role of escrow in securing financial transactions, especially in real estate, and see how it can protect both buyers and sellers.
At-A-Glance
Escrow agreements allow a third party to hold money until certain terms of an agreement are complete.
In real estate, there are two main types of escrow accounts: homebuyer’s escrow and homeowner’s escrow.
With homebuyer’s escrow, the escrow agent holds the funds, only releasing them to the other party after specific steps have been taken.
Some financial transactions, such as real estate purchases and sales, involve several complex steps and large money transfers. To keep buyers and sellers safe and move the sale along, the two parties in a real estate transaction will sometimes bring a third party in to hold funds in escrow.
This article will discuss the purpose of escrow, explaining how it works, and highlighting some benefits and drawbacks of using it.
What Is Escrow?
Putting funds into an escrow account can help protect buyers, sellers, and lenders throughout the mortgage lending process. An escrow agreement allows a neutral third party, typically a title or escrow company, to hold money until the other party or parties meet the terms of their agreement.
It’s important to note that there are two main types of escrow accounts: homebuyer’s escrow, and homeowner’s escrow.
- Homebuyer’s escrow:
With a homebuyer’s escrow account, the account is used to hold earnest money that is put down by the buyer in good faith. As the transaction proceeds, the money will go to the right party according to the terms and conditions of the sale.
- Homeowner’s escrow:
A homeowner’s escrow account holds funds for certain post-purchase expenses, such as homeowner’s insurance premiums and property taxes.1 The mortgage lender is typically the homeowner’s escrow agent.
In this article, we will primarily be considering homebuyer’s escrow.
How Does Escrow Work?
Escrow moves funds and the title in a step-by-step process, providing a secure mechanism for the transaction and mitigating risk on both sides.
Here is how the homebuyer’s escrow process works:
1. Initiation
First, both parties negotiate the terms of the sale. Once they agree on the terms, they look for and appoint an escrow agent. The escrow agent could be a lawyer, escrow company, or title company.
2. Deposit funds
The escrow agent opens an escrow account, where the buyer deposits their earnest money. If the transaction succeeds, this deposit could apply to the down payment.
Once the buyer accepts the offer and the title search is complete, the seller deposits the title into escrow. After that, the buyer deposits money for closing costs and the remainder of the down payment. The mortgage loan then proceeds to closing.
3. Release of funds
Funds and the title release from escrow toward the end of the real estate transaction. The seller receives the down payment and remaining loan proceeds during the closing to complete the sale.
After the escrow agent confirms the conditions of the sale, the title transfers from escrow to the buyer.
Escrow Fees
Escrow fees are typically 1% to 2% of the purchase price of the home.2 However, these will vary, depending on the escrow company and location of the home. Generally the fees are split between the buyer and the seller.
Benefits and Drawbacks of Escrow
While many home purchases utilize escrow, you should consider the benefits and drawbacks before purchasing a home.
Pros for buyers:
- Security: Escrow accounts can help buyers to protect their deposit during a home sale. Since the deposit is being held with a third party, it should be returned according to the agreement.
Cons for buyers:
- Fees: Escrow companies may charge fees for their services and other tasks, making a home purchase more expensive.
- Lack of control: Despite the security escrow offers, some buyers may desire more control over their funds during the transaction. Committing to a transaction by transferring funds to an escrow account means they may forfeit that money if they want to back out of the purchase for a reason that isn’t specified as a contingency in the purchasing agreement.
Pros for sellers:
- Commitment: Because the escrow agent takes the buyer’s deposit and other funds, the buyer will be committed to the purchase to avoid forfeiting funds.
- Security: As with the buyer, escrow offers the seller security since they don’t have to transfer their home title until they receive the funds for the home.
Cons for sellers:
- Time: Finding a reputable escrow agent takes time, and the transaction’s progress may slow if the buyer does not complete their tasks promptly. Funds could also take time to disburse from escrow.
- Opportunity cost: When the buyer commits to the purchase and deposits funds into escrow, the seller locks themselves into the transaction. The seller could miss out on opportunities from other buyers who could be willing to negotiate a more seller-favorable deal.
Frequently Asked Questions
The buyer technically owns the money in the escrow account since they deposited it, however, the escrow agent controls the funds.
Escrow is neither good nor bad; instead, escrow protects the buyer and the seller during a transaction. Escrow has pros and cons, but it can be an effective tool that many people utilize during a home purchase or sale.
You cannot take money out of an escrow account. The account secures funds for both parties, and only the escrow agent can disburse the funds.
The Takeaway
Escrow services hold the funds and sometimes that title, only transferring them when the necessary steps have been completed according to the agreement that is in place. For this reason, escrow can be a useful tool, providing peace of mind for both buyers and sellers.
1 “Mortgage escrow account pros and cons,” Bankrate
2 “Escrow Fees: What They Cost And Who Pays Them,” Rocket Mortgage
Bradley Schnitzer is a writer and email strategist who has covered personal finance and small business topics for over five years. He is passionate about personal finance and helping others understand their money.
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.
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