What is Escrow in Real Estate and How Does It Work?
What is Escrow in Real Estate?
There are a lot of words and terms that are unique in the world of real estate and one of those terms is “Escrow”. The meaning and use of Escrow in real estate transactions are critical to many real estate deals. Many newcomers to the world of real estate want to understand the processes involved in buying real estate or investing in real estate opportunities and a good understanding of what Escrow is and how it is applied in real estate transactions.
A Definition of Escrow
To fully comprehend the concept and application of escrow in real estate transactions, it’s important to grasp its most basic use in transactions of all types. Escrow is not limited to real estate transactions exclusively and it is used in many transactions in business. Listed below is the definition of 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 in Real Estate Transactions
In real estate, escrow usually means a buyer and seller of property working to close the purchase or a financial resource that works as an agent to receive funds and then, later, disburse those funds to the intended recipient according to terms established between the parties. This is what happens with mortgages and funds paid toward homeowners insurance policies and property taxes. By establishing escrow accounts, mortgage companies reduce their risk for insurance coverage for the financed property as well as having the property foreclosed on by a tax agency.
What is Escrow On a Mortgage?
Each month, along with the mortgage payment to retire the mortgage debt, two other amounts are paid as well. One payment goes into a savings account for paying the home owner’s insurance policy. The other payment is saved to pay for the annual property tax bill. By paying smaller amounts each month, the borrower is better able to afford the costs of each expense. The account balances pay the insurance and taxes so that the mortgage holder doesn’t need to be concerned about the bills being paid when they come due each year.
What Does Escrow Pay For On a Mortgage?
In general, escrow accounts are established to pay for two things; an insurance policy that covers the value of the real estate in case of damage or destruction and property taxes that must be paid to local taxing agencies. Homeowners insurance assures the mortgage company if any happens to the property, the value of the insurance will reimburse the homeowner for costs associated with rebuilding or repairing the property. Taxes are important to pay due to the ability to have the property seized by a tax agency for failure to pay property taxes which would leave the mortgage company without collateral for their loan.
What is Escrow Shortage?
The escrow accounts for taxes and homeowners insurance are estimated each year based upon prior costs but also with an allowance for an increase in costs. Because the increases are estimated, they are occasionally in error and the amount of money reserved to pay for the insurance or taxes may not be adequate. In these situations, an Escrow shortage takes place and the shortage of funds must be paid by the homeowner.
What is Estimated Escrow?
Calculations for insurance and/or taxes are adjusted to allow for annual increases and the amount paid into escrow by the homeowner is increased accordingly. In some situations, the amounts for insurance and taxes are over-estimated and the unpaid balances in each account can be rolled over toward the following year’s expenses or refunded to the homeowner. It is also possible a homeowner will be able to reduce their insurance or tax expense which would require the amounts charged for escrow would have to be re-calculated.
What is Escrow Disbursement?
When the annual homeowner’s insurance policy and property taxes come due, the funds held in the two escrow accounts are used to pay those bills by the mortgage company or by a third party agency that has been receiving the funds. Most mortgage companies utilize an outside company to handle this process as it is far less complicated for the mortgage company and the fees are relatively low. This process is preferred by mortgage companies as it also requires less follow-up by the homeowner trying to keep track of the bills and expenses associated with the mortgage.
What is an Escrow Agent?
An Escrow Agent is a third party business that collects escrow payments from mortgage companies and holds those funds until it is time to pay the homeowner’s annual insurance policy cost and the property taxes on the financed property. Some mortgage companies have an in-house escrow agency while many others use an outside company to handle funds and payments. Borrowers are encouraged to research the company used for escrow management to determine its suitability and understand its policies and procedures for receiving and disbursing escrow funds.
What is an Escrow Officer?
The individuals responsible for overseeing and disbursing escrow funds are called an “Escrow Officer”. Escrow companies are certified, bonded, and insured against theft or loss on behalf of their clients with a designated Escrow Officer performing the fiduciary duties associated with handling and managing mortgage owner’s funds. Just like a stockbroker, banker or other financial adviser, an Escrow Officer must qualify and maintain their qualifications to handle escrow accounts.
What is An Escrow Company?
Mortgage lenders often employ an outside escrow company to track, receive, and disburse payments to the various insurance companies and taxing agencies their clients must pay each year. The ability to follow-up on thousands of mortgages with hundreds of different insurers and tax agencies is better managed by a company designed to take care of the complex number of transactions and activities than by the mortgage provider itself. Escrow companies use specialized software and accounting programs and processes to ensure each mortgage is being serviced properly with receipts and disbursements accounted for according to the terms established by the mortgage company with the borrower.
What is Escrow Closing?
In real estate, when the term “Escrow closing” is used, it usually means that money being held by a third party has been disbursed because the contract between the two other parties has been fulfilled. Funds being held in escrow are the property of both the buyer of the property as well as the seller of the property. For mortgages, placing funds into escrow for a mortgage, or a down payment on the mortgage loan is a common occurrence.
What is Escrow Analysis?
Every mortgage provider in the United States is required to conduct an annual review of each mortgagee’s escrow accounts and determine how much money should be paid toward homeowners insurance and taxes. The Federal law is called the Real Estate Settlement Procedures Account or RESPA. The main value to RESPA is the guideline stating a lender can’t require more than two month’s payments above the cost to pay the insurance and taxes as a reserve amount.
What is Escrow Service?
Escrow service provides a secure way to have important funds, documents, and other valuable assets to be in the possession of or under the control of a third party to the transaction being conducted. Escrow services normally charge a fee of 1% to 2% of the transacted amount to pay for the service. Escrow service companies are bonded, insured, and certified by local, state, and federal agencies, depending on their sphere of operations.
What is Escrow Hold Back?
When a mortgage provider calculates the amounts to be paid toward homeowners insurance and property taxes, they are allowed to receive a larger first payment than what would be calculated by dividing the total amount by twelve. As stated above, the RESPA legislation limits the amount that can be required for the escrow account to be established. In addition, when the costs for homeowners insurance or taxes are less than originally estimated, the balance in the escrow account can be held by the mortgage for future payments or refunded to the homeowner.
What is an Escrow Agreement?
The contract written at the time the escrow accounts are established is called an “Escrow Agreement”. It outlines the conditions that must be met before any funds can be disbursed. The Escrow Agreement binds the party holding the funds to specific conditions that will allow the release of the funds. Failure to meet the conditions results in the refunding of the money to the payer with the requirement that a new agreement must be signed before the process can start again.
What is Escrow Surplus?
As discussed above, when the calculations for homeowners insurance or taxes are incorrect and there is a balance remaining in the escrow accounts after paying the expenses, there is an Escrow Surplus. The surplus can be retained in the account for use in the following year’s scheduled payment amount or it can be refunded to the homeowner. Federal law requires amounts over $50 to be refunded to the homeowner unless otherwise directed by the homeowner.