Escrow 101: Importance, Types and Working Methodology

For most people, buying a property is a big deal.

Moving into a new home is a tricky affair. The process consumes so much energy from shortlisting a property to open houses to the final purchase. At the same time, you have to be wary about legal documentation, payments, and commissions. How relieving would it be to have a middleman supervise all of this?

 Escrow, or an escrow agency, acts like a warehouse to store your financial assets before you transport them.

Escrow services are offered as a part of digital mortgage closing software, which automates fund releases, loan closures, and tax management. Escrows are equally important for buyers and sellers in real estate deals. Let’s see how.

Entities that run escrows charge a small commission known as “escrow fees” to legalize and protect your payment.  Buyers and sellers yield control to the third entity, which looks for transactional loopholes and legal violations before deal closure.

So how does the third party do that?

How does escrow work?

Real estate transactions are prone to risky outcomes. Having an escrow company in place assures the buyer and the seller that the process stays safe from forgery.

The homebuyer can set up a savings account with an escrow and deposit the earnest money. After escrow conducts a home inspection, legal verification, and valuation of the property, the escrow company releases funds to the seller. This, in turn, ensures the seller that the buyer is authentic. 

As you pay the earnest money, the seller takes the property off the site, conducts repairs, and helps you apply for a loan. The best type of loan that you can take to pay off the house is a life mortgage loan.

Mortgage companies or lenders can suggest you open a mortgage escrow account with them to pay for homeowner’s insurance and tax bills. They hold a share of your tax payments in advance in an escrow account. That way, the lender can use the escrow account to pay off the taxes and insurance whenever the payment is due. Using escrow on a mortgage means your monthly mortgage payments will be slightly higher than private loan installments.

During the entire loan tenure, the mortgage company clears your tax bills. In case the buyer doesn’t opt for an escrow mortgage and fails to pay off taxes on time, the government can impose a lien on the property. 

It’s also the responsibility of the buyer to finalize their escrow agreement and pay the closing costs of the loan. At close, your mortgage account and escrow account are created.  All of this is recorded to make sure the money has been disbursed properly and that both parties are happy with the final outcome. Once the transaction is complete, escrow is closed.

Types of escrow accounts

Monetary security is essential for potential homeowners. An escrow account works under a tightly regulated framework, with no wiggle room for theft or fraud. When a mediator takes charge of funds, the buyer and seller’s assets are in safe hands.

To find out which escrow service is the best, consulting the local homeowners association (HOA) is a good idea. 

Escrow in real estate

In real estate, escrow isn’t a one-trick pony. The seller and the buyer have to undergo a number of re-runs to ensure that every real estate transaction is recorded with an escrow agent. Before setting up an escrow, every homebuyer should be aware of these aspects.

• Home value: If you’re a first-time homebuyer, compare the property’s market value with the quoted value of the seller. Sometimes, sellers raise the home value in the market. During loan evaluation, if your lender finds a discrepancy between the quoted price and the market value of the property, you will be denied a loan. Check the sale deed and valuation of your potential house before rolling the dollars in.
  

• Facility maintenance: Check for repairs, add-ons, replacement, and electric operationality of the house before setting up an escrow account. Lenders often do macro checks, which means they don’t list out minor defaults in the house at the time of showings.
  

• Home loan or mortgage: Decide whether your lender or provider wants to set up an escrow. If so, consult them about which escrow service would be the best to invest your funds in. Be wary of what you submit in an escrow account.
  

• Homeowner’s insurance and property taxes: Reserve a part of your monthly income for property tax and homeowner’s insurance payments. Availability of cash is mandatory if you want to avoid a financial shortfall.
  

• Title search: A title search determines that there are no liabilities on the property you’re about to buy. Do an exhaustive title search and check the past history of the house. Ensure there are no liens, mortgage payments, or pending utility bills.
  

• Purchase hazard insurance: Hazard or homeowner’s insurance is your obligation to the state you live in. Escrow disburses the funds for homeowner insurance and other insurance on your behalf so that you don’t have any debt in the future. 
  

• Final walkthrough: Re-inspect all legal deeds and possession documents before transferring your money to the mortgage company. If any unexpected issue occurs, you might lose a large chunk of your earnest money.
• Closing: Submit your paperwork to the mortgage company, along with the escrow approval. The end choice of whether to use an escrow for loan disbursement or not is with the lender. Choosing an escrow would mean slightly higher loan installments, tax payments, and insurance costs.

Escrows in the stock market

In the stock market, the shareholders don’t have direct ownership of the shareholder equity. For example, multinational companies retain their top-line of workforce through additional shares. However, the employees cannot monetize these shares. They’re held in an escrow account that liquidates only after the employee spends a bond duration with the company. 

Companies also set some restrictions on how employees can use these shares. The shares will only be credited to them if they satisfy the escrow agent’s pre-verification checks.

Escrows in mergers and acquisitions

During a company or an asset merger, escrows record the assets involved, patents and trademarks, and other important documents in a repository. Escrow is a safe option to protect fixed assets, current assets, and various marketable securities of the dissolving company. Signing up for escrow with a good faith deposit showcases your willingness to take responsibility for assets. 

The buyer and seller in a mergers and acquisitions process need a multitude of government approvals, staff adjustment, and cross-border transactions to merge entities successfully. Escrow does all the legwork and reduces the financial burden on finance and accounting teams.

Escrows in an online transaction

Although escrows can be used for any business transaction, it’s wisest to set it up for big-pocket transactions. If you’re buying a luxury watch, a car, or a heavy piece of machinery, protect your funds with an escrow. 

Escrow conducts a five-step run-through before releasing your deposit to the seller

• Buyer-seller agreement: When the buyer approaches an escrow agent, the agent checks for seller information, delivery date, shipping methods, and quality inspection of the product or goods.

• Buyer Payment: After the mandatory checks, you can open an escrow account and deposit your funds under legal guidelines. Your payment is recorded and kept as proof on an income statement.
  

• Dropshipping: The funds are released to the seller only after the product arrives at its destination in a decent condition.
• Buyer’s approval: At any stage of escrow service, if the buyer feels unsatisfied with the product, the money is forfeited and refunded.
• Payment release: After scheduled verification and supervision, the payment is released.

What does it mean to fall out of escrow?

If something goes wrong with the transaction, the property can fall out of escrow. This means that the deal is unable to work in its current state because one or both parties cannot meet a condition in the agreement.

Although this situation isn’t ideal for either party, it doesn’t necessarily mean the deal is dead – it may take longer to close. The buyer and the seller can renegotiate the terms and agree to make the necessary changes to move forward. What this looks like for each party varies depending on the reason the deal fell out of escrow in the first place.

The best way to avoid falling out of escrow is to prevent it from happening altogether. Prior to making an offer, the buyer should have a reasonable budget in mind and be confident they will qualify for the loan. 

On the other end, the seller should be transparent about any damage to the property. This way, the inspection won’t unveil any new problems that could jeopardize the contract.

What is the escrow balance?

Say you apply for a loan for your new home. Along with principal and interest, escrow agents may ask you to pay homeowners insurance in advance and keep a certain amount of cash reserves in your escrow account. It doesn’t mean you’re double paying for insurance or property tax, but simply maintaining an escrow balance. 

Whenever your payment is due, the lender will use your balance to disburse the money. Each month, you’ll receive an escrow account statement from the lender.

What is an escrow account?

An escrow account is different than the escrow that occurs during the closing process. In short, an escrow account is used by a real estate buyer to manage their homeowner's insurance and property tax payments.

After closing on a property, the buyer can open an escrow account with their loan provider, where additional funds for insurance and tax payments will be held. Each month, the property owner will pay a certain amount to cover these expenses in addition to their regular mortgage payment. At the time that these bills are due, the lender will pay them on behalf of the property owner. As long as the owner is making their monthly payments on time, the lender is responsible for also paying on time.

For most property owners, having an escrow account is a big convenience. It’s one less bill to worry about, and who doesn’t want that?

Benefits of an escrow account

• For homebuyers, escrow protects the earnest money until the deal gets finalized. Holding funds with escrow helps the buyer supervise the property completely before investing. If they detect any fault and no longer wish to proceed, the escrow agency refunds the money.
• For homeowners, escrow can be a great way to pay off property and insurance taxes on time. It does all the heavy lifting in terms of maintaining tax deadlines and disbursing payments.
• For internet buyers, escrows monitor the product’s entire shipping journey. When the product is safely in the hands of the buyer, escrows release funds to the seller.
• For lenders, opening an escrow account helps collect requisite funds from the loanee and pay off recurrent tax bills.

Common challenges of escrow

Not everyone can afford to invest their money in escrow because it charges a commission from buyers and sellers. Sometimes, having an escrow for real estate transactions only draws out the process of loan disbursement and documentation. 

Some common challenges associated with escrows are here for you to consider.

• Opening an escrow account means a lack of trust between buyer and seller. This phenomenon can create bitter feelings among parties and cause communication gaps.
• During tax foreclosures, escrows might not be able to disburse funds to the lender on time. Failure to pay taxes can result in potential seizure of property.
• To qualify for an escrow service, the buyer and seller go through several steps of document verification and loan eligibility. This might frustrate both parties.
• Escrow checks whether a property’s valuation matches its appraised value. In this case, the seller cannot raise the selling price and May encounter a loss.

Escrow: Frequently asked questions (FAQs)

What is an escrow advance?

Escrow advances are reserves collected by escrow companies in advance to pay off property taxes and insurance when they’re due. The reserve is collected to ensure that your funds don’t run out and you don’t land in an escrow shortfall.

What is an escrow shortage?

A lack of funds in your escrow account might result in an escrow shortage. Escrow shortage is reflected in your monthly loan statement, which is a cue for the loanee to submit required checks to the escrow agency.

How do I lower escrow payments?

Escrow payments can be lowered by negotiating your property mortgage tax. If you think the tax amount is too high, you can call your local assessor and reassess it. As your mortgage company also deducts their commission from your escrow balance, you can opt for cancellation of your mortgage insurance.   

Why does escrow increase?

Escrow increases due to a rise in tax amount, insurance interest, and mortgage interest. Also, escrow collects six months or a year worth of payments in advance, which leads to higher costs.

How do I open an escrow account?

To set up an escrow account, first, you need to consult a homeowner’s association to learn about property rules and guidelines. Then, through your seller’s real estate agents, you can survey your residential area for the best escrow company offering affordable interests. Escrow is set up via phone, email, website, or person.

What is an escrow agreement?

An escrow agreement is a contract signed by two parties attesting that escrow is responsible for keeping your money until the legal obligations are met.

All heroes are escrows!

As the graph of fraudulent financial scams grows,  escrow processes are vital to protect your money and assets. Shaking hands with an intermediator helps understand the other party better and act accordingly. Whether it’s real estate, e-commerce, or retail, escrow accounts can save you from a million-dollar heist!

While thinking about incoming business transactions, don’t fall behind on other opportunities! Learn how you can double your economic profit by investing your funds smartly and optimizing implicit resources.