Escrow

What Is Escrow?

Escrow is a legal concept describing a financial instrument whereby an asset or escrow money is held by a third party on behalf of two other parties that are in the process of completing a transaction. Escrow accounts might include escrow fees managed by agents who hold the funds or assets until receiving appropriate instructions or until the fulfillment of predetermined contractual obligations. Money, securities, funds, and other assets can all be held in escrow. It is often suggested as a replacement for a certified or cashier's check.

Key Takeaways

  • Escrow is the use of a third party, which holds an asset or funds before they are transferred from one party to another.
  • The third-party holds the funds until both parties have fulfilled their contractual requirements.
  • Escrow is associated with real estate transactions, but it can apply to any situation where funds will pass from one party to another.
  • With real estate, escrow can be used when purchasing a home, but also for the life of a mortgage.
  • Online escrow has been on the rise as a way to offer secure transactions for high-ticket items, such as art or jewelry.

Understanding Escrow

Escrow is a process used when two parties are in the process of completing a transaction, and there is uncertainty over whether one party or another will be able to fulfill their obligations. Contexts that use escrow include Internet transactions, banking, intellectual property, real estate, mergers and acquisitions, and law, and many more.

Consider a company that is selling goods internationally. That company requires assurance that it will receive payment when the goods reach their destination. The buyer, for their part, is prepared to pay for the goods only if they arrive in good condition. The buyer can place the funds in escrow with an agent with instructions to disburse them to the seller once the goods arrive in a suitable state. This way, both parties are safe, and the transaction can proceed.

For real estate, there are two escrow accounts—the first is when you’re buying a home, and the other is for the life of the mortgage.

Types of Escrow

Escrow and Real Estate

Escrow accounts can apply to real estate transactions. Placing the funds in escrow allows the buyer to perform due diligence on a potential acquisition. Escrow accounts also assure the seller that the buyer can close on the purchase. For example, an escrow account can be used for the sale of a house. If there are conditions attached to the sale, such as the passing of an inspection, the buyer and seller may agree to use escrow.

In this case, the buyer of the property deposits the payment amount for the house in an escrow account held by a third party. The seller can proceed with house inspections confident that the funds are there, and the buyer is capable of making payment. The amount in escrow is then transferred to the seller once all the conditions for the sale are satisfied.

Escrow can also refer to an escrow account that is set up at the time of mortgage closing. With this, the escrow account houses future homeowners insurance and property tax payments. A portion of the monthly mortgage payment is deposited into the escrow account to cover these payments. Thus, mortgagees that set up an escrow account (in some cases it's required by the lender) will have higher payments than those who do not; however, they will also not have to worry about paying the yearly premiums or property tax bills as they're already paying it monthly into their escrow account.

Escrow and the Stock Market

Stocks are often issued in escrow. In this case, while the shareholder is the real owner of the stock, the shareholder has limited rights when it comes to the disposal of the stock. For example, executives who receive stock as a bonus to their compensation often must wait for an escrow period to pass before they can sell the stock. Stock bonuses are a tactic used to retain top executives.

Escrow and Online Sales

Online escrow, like real estate and stock market escrow, protects the buyer and seller from fraud or nonpayment. An online platform acts as the middleman for online product sales. The buyers send the money to an escrow service, such as escrow.com, and they hold the money until the product is received. 

Once the product is delivered and verified, an online escrow provider will release funds to the seller. For the most part, escrow services are not used; however, in cases that it is, it’s generally best suited for high-ticket items, such as jewelry or art. The online escrow company charges a fee for the service.

Advantages and Disadvantages of Escrow

Escrow can provide security for high-ticket transactions, but that service generally comes with a fee. Escrow for mortgages can help protect the borrower and lender from potentially underpaid property taxes or homeowners insurance. 

On the downside, these numbers are generally estimated, so you may end up overpaying (or underpaying) into your escrow account, which may lead to an adjustment when it comes time to make the annual payments. For the ease that monthly escrow payments offer, this requires a higher mortgage payment than if the payment only included principal and interest.

Pros
  • Provides protection during a transaction, notably a real estate transaction (which tends to be sizable)

  • Can allow for the monthly payment of insurance and taxes (avoiding having to pay a lump sum).

  • Escrow is beneficial for both the buyer and seller when high-ticket items are involved.

Cons
  • Higher mortgage payments (if escrow is used for taxes and insurance)

  • Estimates might be incorrect for the amount of taxes.

  • For online transactions, escrow fees might be higher than other platforms, such as PayPal.

Example of Escrow

Homebuyers often see themselves embrace escrow twice. First, say John is looking to buy a home. John finds a home and decides to make an offer. The offer is accepted and he must put his earnest money, say $5,000, into escrow. The money put in escrow allows the seller to know you’re serious about potentially buying the property, and in return, the seller will take the property off the market and finalize repairs, etc. All goes well and at the time of the purchase the escrow money is transferred to the seller and the purchase price is reduced by $5,000.

At the closing, the buyer agrees to set up an escrow account with the lender to pay property taxes and homeowners insurance. John’s monthly payments, thus, looks like this: 

  • $1,000 for principal and interest
  • $100 for homeowners insurance
  • $300 for property taxes 
  • Total monthly mortgage payment of $1,400

Then when the yearly taxes and insurance come due, the lender will pay those balances from the escrow account. Some lenders require an escrow account to ensure both of these are paid on time. If taxes go unpaid a lien could be placed on the property, which is not in the best interest of the lender.

Escrow FAQs

What Is Escrow on a House?

Escrow for buying a home is an account (escrow account) where money from the potential homebuyer is deposited. Required escrow is generally 1% to 2% of the asking price for a home. The money is required to ensure the buyer is seriously considering the home and has the funds to make the purchase. In return, the seller will usually take the market off the market and allow the potential buyer access to the home for inspections.

How Does an Escrow Work?

Escrow required by lenders for a mortgage involves monthly payments for property taxes and homeowners insurance. If escrow is required by the lender (or requested by the borrower) the mortgage payment will include principal and interest for the loan, as well as allocated amounts for property taxes and homeowners insurance. The lender will collect these amounts for taxes and insurance monthly and keep them in the escrow account, and then, when the annual bills come due, make the appropriate payments.

How Long Do You Pay Escrow?

Escrow for mortgages can last for the length of the loan. Sometimes lenders do not require that escrow be set up. Lenders have different requirements for removing escrow, however. If you're required to initially set up an escrow account, many lenders will entertain a written request to end escrow after you've made 12 on-time mortgage payments, and your loan-to-value must generally be 80% or lower.

Is Escrow Good or Bad?

Escrow is generally considered good, as it protects the buyer and seller of a transaction. As well, escrow as part of mortgage payments is generally good for the lender and helps the buyer by ensuring property taxes and homeowners insurance are paid on time.

What Is an Escrow Disbursement?

An escrow disbursement is a payment out of an escrow account, usually by the lender on behalf of a borrower to cover property taxes and homeowners insurance.

Bottom Line

Escrow can be used for various transactions, including real estate, stock issuances, and online sales. Money from the buyer is held in an escrow account until the transaction is complete, or the buyer is able to receive or verify the condition of the product. Once the buyer agrees to the transaction the money is released to the seller from the escrow account. The company managing the escrow account generally takes a fee for performing the third-party service.