Real estate is filled with unfamiliar terms that can easily throw off a home buyer or seller. Amortization? Balloon mortgages? Equity returns? It’s enough to confuse even the most diligent of non-real estate professionals, and a big part of the reason that it’s so important to work with a good agent when you’re ready to either buy or sell a property. At the top of the list of confusing real estate terms is “escrow,” the name for a process that plays a huge role in a real estate transaction but which many people have trouble fully grasping—including current home purchasers who have paid into escrow without even knowing the what or why behind it. But have no fear—we’re here to break it down for you. Read on for a quick and simple guide to understanding real estate escrow.
What is real estate escrow?
Escrow is when a neutral third party holds on to funds during a transaction. In real estate, it’s used as a way to protect both the buyer and seller during the home purchasing process. After a property is purchased, the new homeowner continues to put money into escrow as a means of paying mortgage and insurance payments, though this is a little different than real estate escrow (we’ll get to it later).
The purpose of escrow is two-fold. It guarantees the seller that the buyer has the funds needed for the purchase and that the money will be handed over once the title is transferred, and it guarantees the buyer that they won’t be scammed by a fraudulent seller who actually holds no claim to a title. Ultimately, escrow helps ensure trust in a high-stakes transaction where neither party may be familiar with each other and where both have a lot to lose.
Escrow is arranged by an escrow agent, a neutral person or entity who is entrusted with holding payments until certain conditions have been met, usually a transfer of title. Because escrow agents play an important role in completing real estate transactions, they are sometimes referred to as title agents.
You will typically not be responsible for securing your own escrow agent. Instead, your broker or lender will facilitate the process—you just have to supply the money.
What if you want to choose your own escrow agent?
As a principal member of the transaction, you do have the right to select your own escrow agent. You may want to do this if you have a strong recommendation for a particular agent, or if you want to be as knowledgeable as you can on the various parties involved in your home sale or purchase. Usually, it is the seller who has the final decision making power on which title company is used for escrow.
Understanding real estate escrow becomes a lot easier once you understand its benefits. Escrow provides assurance for all major parties in a real estate transaction—the buyer, the seller, and the lender—that their interests, and their funds, are protected. Your escrow agent will track and verify the transfer of key variables; most notably, the transfer of the property title from the seller to the buyer and the transfer of funds from the buyer to the seller. It also helps assure the lender that the loan money is going to the right place.
As a buyer, would you feel comfortable transferring thousands of dollars to a seller you’ve never met without knowing for sure that you would receive the title in return? And as a seller, would you really want to take the risk of handing over a title without a complete guarantee that the buyer is good for the purchase price? Escrow protections help give all parties peace of mind, and help ensure that a real estate transaction goes through as easily as possible.
Escrow and earnest money
Escrow and earnest money are two terms that go hand in hand, but they’re not the same thing. Earnest money is an amount paid in to escrow early on in the home purchase process to essentially put a “hold” on the property for the buyer. It’s a way of showing serious intent that the buyer is going to stay true to their offer, and protects sellers from having to deal with buyers putting out multiple offers or going into negotiations on multiple properties. At closing, the earnest money payment is generally taken out of escrow and put toward the buyer’s down payment.
Escrow vs. escrow account
Here’s another set of terms that are closely related but not to be confused with each other. Many people have trouble understanding real estate escrow because they mistake it for an escrow account, so it’s important to know the difference.
An escrow account is a separate account managed by a lender to collect advance insurance payments and tax payments from a homeowner. Usually, a lender will add up the total amount due for these payments in a year, divide it by 12, and tack on that extra amount to each mortgage payment. When those payments are due to either a homeowners insurance agency or the IRS, the lender pays them for the homeowner out of the escrow account. Many states, but not all, require lenders to pay interest to homeowners on their escrow account.
Online escrow companies
If you’ve done any previous research on escrow, you may have come across online escrow companies. While the main goal of online escrow is similar to that of real estate escrow, online escrow companies help build trust between buyers and sellers in online purchases—not in real estate transactions. For example, if you wanted to buy an expensive used car through an auction site, you would want to hold your payment in escrow until the car has been delivered, instead of just crossing your fingers and hoping that you’re not being scammed.
Though the idea behind real estate escrow and online escrow are very much the same, you won’t be using an online escrow company to buy or sell a home. Your escrow agent will be either a qualified attorney or a third party institution pre-approved by your broker or lender or chosen by the seller based on reliable recommendations.
The escrow process
By this point, you should have a good idea of what escrow is, but what about the process behind it? The escrow amount generally ranges from between 1% to 3% of the total sale price, and is deposited into escrow after an offer is accepted by the seller. The neutral third party safely holds on to the funds until closing when the sale is finalized and the title is transferred over. The total time that funds sit in escrow depends on the length of the closing period. During escrow, the funds are inaccessible by both the buyer and the seller. If the deal falls through, the escrow funds will be returned to the buyer.
Your role in the escrow process
As the buyer or seller in a real estate transaction, you play an important role in the escrow process. In addition to the buyer being responsible for depositing funds into escrow on time, there are several other things that both parties can do to make the process run smoothly. These include:
Reading over all escrow-related documents and making sure that you understand them. If you have a question or need some more clarification, ask your real estate agent or lender to help you.
Being available to quickly respond to any questions or necessary next steps as the process moves forward.
Giving the closing documents a thorough read through so that there are no surprises or last-minute questions once the deal is ready to be finalized.
Holding on to your escrow-related documents for administrative and tax purposes.
Most of the real work on escrow will be done behind the scenes, with the neutral third party responsible for collecting and dispersing funds at the right time. If you ever have any questions about your escrow, including timing, speak with your lender directly.
Understanding real estate escrow is all about understanding why it exists in the first place. And while it may seem like just one more expensive task in the closing process, its benefits for both buyers and sellers mean that it’s well worth a couple of extra steps. Buying or selling a home is a major transaction, and the more protections each party has in place, the better. As confusing as escrow might be, it’s an essential part of ensuring that your real estate transaction is a success. SBBM