What Is Escrow? Types, Benefits and Best Practices

Buying a home isn't just a financial decision; it’s a major life milestone.

From navigating legal documents to coordinating with agents, lenders, and sellers, real estate transactions come with high stakes and even higher complexity. It’s not just about exchanging money; it’s about making sure every box is checked and every party is protected.

That’s why most deals rely on an added layer of security: escrow. It’s a process designed to hold funds, verify terms, and keep everything fair and accountable until closing day.

This setup creates a safety net against fraud, double payments, or premature fund transfers. In modern real estate workflows, it’s often built into digital mortgage closing software, which helps manage tasks like disbursement, tax payments, and loan finalization.

Now that we’ve defined it, let’s look at what escrow actually does and why it plays such a vital role in real estate, online commerce, and business finance.

How does escrow work in real estate?

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. Here’s how a standard process works:

• Buyer deposits earnest money: Once a purchase offer is accepted, the buyer deposits earnest money into an escrow account. An earnest money deposit shows the seller that the buyer is serious about making the purchase and has the financial means to follow through with it.
• Escrow agent begins coordination: The escrow company verifies the property title, works with both parties to ensure inspections are scheduled, and confirms the buyer’s financing and appraisal. 
• Repairs, walkthroughs, and final prep: During escrow, the seller typically completes agreed-upon repairs, removes the listing, and prepares the property for closing. The buyer has the opportunity to do a final walkthrough to confirm that the property’s condition meets expectations.
• Legal checks: An exhaustive title search is performed to make sure there are no existing liens, unpaid taxes, or ownership disputes. Any unresolved legal or financial obligations can delay or cancel the transaction.
• Closing and fund release: Once all inspections, legal verifications, and loan conditions are satisfied, the escrow agent distributes the funds to the seller, records the new ownership, and finalizes the sale. At this point, the deal officially “closes,” and the escrow process ends.

What is an escrow account?

An escrow account is different from the short-term escrow used during the home buying process. It is used to pay property taxes and homeowners' insurance on your behalf.

In many cases, lenders require buyers to set up a mortgage escrow account as part of the loan agreement. Once the home purchase is finalized, the lender creates the account and begins collecting funds as part of your monthly mortgage payment. These funds are then held until tax and insurance bills are due, at which point the lender pays them directly.

Because your mortgage payment now includes these additional costs, it may be slightly higher than a loan without escrow. But the trade-off is fewer surprises, fewer deadlines, and far less risk of missing a payment.

What is escrow balance and how is it used?

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 are the other types of escrow accounts?

Escrow accounts operate within strict regulations, minimizing the risk of fraud or mismanagement. When a mediator takes charge of funds, the buyer and seller’s assets are in safe hands.

Before we explore the various types of escrow accounts besides real estate escrow, let's quickly compare them, including who uses each type, how they are released, and the risks involved.

What is a stock market escrow account?

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.

How is escrow used 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 adjustments, and cross-border transactions to merge entities successfully. Escrow does all the legwork and reduces the financial burden on finance and accounting teams.

How does escrow work for online transactions?

Although escrows can be used for any business transaction, it’s wisest to set them 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 happens when a deal falls 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 why 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 hand, the seller should be transparent about any damage to the property. This way, the inspection will not uncover any new problems that could jeopardize the contract.

What is an escrow shortage and how do you fix it?

An escrow shortage happens when there’s not enough money in your escrow account to cover upcoming property taxes or insurance premiums. This often results from underestimating costs or unexpected increases in tax assessments or insurance rates.

If the shortage remains unaddressed, the lender may apply late fees or initiate additional escrow draws, which can lead to further financial pressure. In extreme cases, consistent shortages may even risk your tax or insurance payments being missed, exposing you to legal or coverage-related consequences.

How to fix an escrow shortage

Upon identifying an escrow shortage, lenders usually offer several options to address the deficit, allowing homeowners to choose the most suitable repayment method. Here’s how most handle it:

• Pay the full amount upfront: You can choose to cover the entire shortage in a single lump-sum payment. This keeps your monthly mortgage payment stable, but your overall payment may still go up if your property taxes or insurance premiums have increased permanently.
• Spread the cost over 12 months: If a one-time payment isn’t practical, you can divide the shortage across your next 12 mortgage payments. It’s a manageable way to catch up, but your monthly bill will temporarily be higher.
• Combine partial and monthly payments: Some lenders offer a middle ground, pay a portion of the shortage now, and roll the rest into future payments. It’s a flexible option that eases financial strain while addressing the shortfall.

What are the benefits of an escrow account?

Depositing your funds in escrow reduces the probability of future fraud. If a buyer opens an escrow account, the agent looks into every nook and cranny of that purchase transaction before depositing funds to the seller.

That’s not the only advantage of opening 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 buyer's hands, escrows release funds to the seller.
• For lenders, opening an escrow account helps collect the requisite funds from the loanee and pay off recurrent tax bills.

Here's a quick side-by-side look at the key benefits and drawbacks to help you make an informed decision.

What are the challenges and risks 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 delays the 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 the potential seizure of property.
• To qualify for an escrow service, the buyer and seller must go through several steps of document verification and loan eligibility, which might frustrate both parties.
• Escrow checks whether a property’s valuation matches its appraised value. If it does, the seller cannot raise the selling price and may encounter a loss.

Escrow: Frequently asked questions (FAQs)

Got more questions? We have the answers.

What is an escrow agreement?

An escrow agreement is a legal contract between the buyer, seller, and escrow agent. It defines what funds or assets will be held, under what conditions they’ll be released, and each party’s responsibilities. It’s essential for protecting all sides in high-value transactions.

How do I open an escrow account?

To open an escrow account for a home loan or property purchase, follow these steps.

• Consult local experts: Reach out to your homeowner’s association or real estate agent to understand local escrow requirements and recommendations.
• Research escrow providers: Compare licensed escrow companies in your area based on reputation, rates, and service terms.
• Review terms and fees: Examine the contract carefully, including escrow fees, timelines, and conditions for fund release.
• Fund the account: Deposit the required amount according to your purchase or loan agreement.
• Confirm disbursement rules: Ensure all parties agree on how and when the funds will be released.
• Choose a setup method: Escrow accounts can be initiated by phone, email, website, or in person.

Is escrow mandatory for home loans?

Escrow is not always mandatory, but is often required if your down payment is less than 20% or if you have a government-backed loan (like FHA). Some conventional loans allow borrowers to waive escrow if they meet certain criteria.

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.

Why does my escrow payment increase?

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

How do I lower escrow payments?

Escrow payments can be lowered by negotiating your property's 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 its commission from your escrow balance, you can opt for cancellation of your mortgage insurance.

Can I cancel my mortgage escrow account?

You can cancel your mortgage escrow account in cases where:

• You've built enough home equity (typically 20% or more)
• Your lender allows escrow waivers
• You’ve maintained a solid payment history

Keep in mind that without escrow, you’ll be responsible for paying taxes and insurance directly.

Do you get escrow money back at closing?

Yes. If there's a surplus in your escrow account after closing or refinancing, your lender may refund the excess within 20 days. The refund depends on your loan terms and account balance at the time of settlement.

The final word on escrow

Escrow adds structure, transparency, and security to real estate transactions. By ensuring that funds and paperwork are only exchanged when every condition is satisfied, it protects all parties and helps deals close smoothly.

If you're planning a property transaction or investment, understanding how escrow works isn't just helpful, it's essential for reducing risk and gaining peace of mind.

Looking to take control of your property finances? Explore real estate investment management tools to track assets, manage deals, and optimize returns with confidence.

This article was originally published in 2023. It has been updated with new information.