Escrow: What It Is and How It Works In Real Estate

Izabelle Hundrev
Izabelle Hundrev  |  May 14, 2019

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

Real estate is expensive and securing funding for a property can be a long and arduous process no matter the buyer’s financial situation. Since you’re dealing with large sums of money during the closing phase, there are steps laid out in order to protect each party involved in the transaction.

One of these steps is going through the process of escrow.

Real estate terminology can be confusing, even for the veteran real estate agent or buyer. In this article, we’ll break down the definition of escrow and share how it affects buyers and sellers during the closing process.

Understanding escrow in real estate

In short, escrow is an easy way to moderate a big transaction to ensure that all parties are happy. When it comes to large sums of money, like those that are required when purchasing a property, there’s little room for error. Going through a third party is an important security measure that protects both the buyer and seller before the deal is closed.

buyer and seller during escrow

How does the escrow process work?

During negotiations, the buyer and seller together will select which escrow officer or company they’d like to work with. Once the buyer is ready to make an offer on the property, they will make their earnest money deposit. This deposit, along with any additional contracts or paperwork, will be collected by the escrow officer. The third-party will hold all of the funds and documentation in a specified account, where neither the buyer or seller will be able to touch it. At this point, the real estate transaction is considered to be in escrow.

TIP: An earnest money deposit shows the seller that the buyer is serious about making the purchase and have the financial means to follow through with it.

During this time period, it’s the responsibility of the buyer to finalize their mortgage agreement. Once the loan clears, the escrow officer will handle the transfer of funds to the seller, as well as any paperwork that may come with it, such as a property deed. All of this will be recorded to ensure the money has been disbursed properly, and that both parties are happy with the final outcome. Once the transaction is complete, escrow is closed.

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 cannot go through in its current state because one, or both parties, cannot meet a condition in the agreement.

There are a variety of reasons why a property can fall out of escrow, including:

  • The appraisal is too low
  • Problems with the property are revealed during inspection
  • The buyer did not qualify for financing

Although this situation is not ideal for either party, it doesn’t necessarily mean the deal is dead – it may just take longer to close. The buyer and the seller can renegotiate the terms and agree to make the necessary changes required to move forward. What this looks like for each party will vary 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 or potential problems with the property. This way, the inspection won’t unveil any new problems that could jeopardize the contract.

How much is escrow on a property?

Escrow fees are one small portion of the overall closing costs involved in buying and selling real estate property. The fees pay the escrow company or officer for their services. The costs will vary, but in most cases, they range between one and two percent of the overall cost of the property.

During negotiations, the buyer and seller discuss who will be responsible for covering the escrow fees. It’s fair to split the cost, but it’s not always the case.

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 homeowners 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 the amount of 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?

NOTE: Not every buyer will be required to open an escrow account. This will be determined by the loan provider and vary based on the type of mortgage loan.

Closing the deal

While it may be a headache to deal with, escrow exists to mitigate risk. The process was put in place to ensure that everyone is happy with the final outcome of a real estate transaction, and their money is protected along the way.

Looking to brush up on your real estate terminology? Check out this complete glossary of all the important terms you should know.

Read more: 50 Real Estate Terms from A to Z →

Izabelle Hundrev
Author

Izabelle Hundrev

Izabelle is a Content Marketing Associate who joined G2 in April 2018. After earning a degree in Journalism from the University of Missouri, Izabelle moved back to her hometown of Chicago in pursuit of a career and deep dish pizza. Outside of work, she is passionate about all things pop culture, food, and travel.