What is Escrow and Why is it Important?

When two parties are “in escrow,” they are entering into an agreement designed to make major transactions—like mortgage agreements—more secure. Escrow is a contractual agreement that requires a third party to hold and dispense funds or property for all parties involved in a transaction. Whether the funds are disbursed depends on whether all the conditions in the contract are met by the involved parties. It helps regulate the terms of the deal by keeping both parties accountable to the terms of the contract since the funds are only released after all terms of the signed contract are met. This process is supervised by an objective, third-party escrow company. While payment is “in escrow,” the funds are placed in a secure location where the money is protected from fraud.


This system is especially important for financial exchanges that involve large sums of money since there are often many terms to the associated contract. In the case of an exchange of goods, like in international sales, there are a number of obligations that need to be fulfilled before the funds can be released. For example, the seller will want confirmation that it will receive the funds it is owed when the goods reach their destination overseas. The buyer will want to make sure the goods are received to go out for distribution before any payment is handed over. An escrow agreement protects both parties throughout these processes, sometimes as a part of the ongoing, long-term operations. 


What does this mean for buying a home? 

Since real estate transactions are usually one-time deals involving larger sums of money, escrow contracts are almost always used to help facilitate the transfer of funds. A representative from the third-party escrow company called an “escrow officer” (usually a lawyer), will help manage the terms of the contract to ensure that both the seller and buyer meet the agreed terms prior to the distribution of the funds. This is particularly useful when the contracts are long or involved, since the parties may have trouble keeping track of the requirements (e.g. a long list of required home improvements or home safety updates prior to the proposed sale). 


The escrow representative keeps track of all the details like the terms of the contract are met and notes if any are not. This ensures that the sale goes smoothly and that both parties are held accountable for completing the terms laid out by the contract. It is in the best interest of the escrow officer to make sure all terms are met successfully since that individual usually receives 1% to 2% of the deal cost. Once the deal has “closed,” the escrow representative records all the details about the transaction and confirms that all terms were met. 



What does this mean for my mortgage? 

If you will need to take out a mortgage to cover the cost of your home loan, keep in mind that you and your lender may also enter into an escrow agreement. Mortgage lenders often use third party escrow accounts to hold the money for insurance and property tax purposes. If this is the case, you will be responsible for paying the estimated tax and insurance costs, including interest. This may seem like a hefty requirement upfront, but rest assured that at the end of the year the lender will need to adjust your monthly amount to match the reported tax and insurance amounts. If you paid too little, usually you can make up the difference over the course of a year. If you paid too much upfront (more common), you will receive a refund from the lender. 


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