Escrow is one of those mysterious-sounding aspects of home mortgages that seem designed to confuse new home buyers. But if you look at it carefully, the benefits of escrow often outweigh the extra complexity.
What is escrow? The legal definition is quite broad: “A deed, a bond, money, or a piece of property held in trust by a third party to be turned over to the grantee only upon fulfillment of a condition.” (Source: Merriam-Webster)
In practice, this usually means money that’s held in a separate account for one of two purposes: to serve as a good-faith payment or to pay for specific mortgage-related expenses. So let’s talk about why and when you’d need to use escrow.
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The main reason that people (and mortgage lenders) use escrow is that it adds a layer of security to the home-buying and mortgage processes. Although escrow is used slightly differently at the home-buying stage than it is during the life of a home loan, the principle of holding funds remains the same.
How does escrow work? Well, let’s say you want to buy a classic car from someone a few states away. You might arrange to put the purchase money in an escrow account held by a third party; this lets the seller know you are serious about buying the car. However, the account holder will not release the funds to the seller until the car has been delivered in good condition; this protects you from any misrepresentation by the seller. Both the seller and the buyer are protected.
You might require escrow at two phases in your home-buying journey: during the purchase process and during the life of the loan. Let’s consider the real estate purchase first.
It’s common for home buyers to pay a portion of the down payment (known as “earnest money” or a “good-faith payment”) into an escrow account soon after their offer is accepted. If the deal goes through, you’ll use this money as part of your down payment; if the deal is canceled due to a failed home inspection or similar reason, you’ll get the money back.
In this case, the escrow is used as a good-faith gesture that the home buyer is serious about completing the purchase. This can make you a more attractive candidate.
Your mortgage lender might also require an escrow account as part of the terms of your mortgage. In this case, the escrow account holds funds for property taxes and homeowner’s insurance. Lenders will pay your home-related taxes and insurance out of this amount to ensure that your home is not under-insured and that all taxes are paid. However, if the mortgage company doesn’t gather enough money to satisfy these expenses, you’ll be on the hook for more funds. The good news is that you’ll get a refund if they’ve collected too much.
As it turns out, escrow is a sensible precaution for sellers, buyers, and lenders. If you’d like some expert advice on dealing with the complexities of home mortgages, contact us at Mortgage 1. We’re here to help!