The homebuying process can be filled with foreign terms. For most people, escrow likely falls on that list. Below, we explain what it means (and why it matters) both before and after the sale.
Escrow is an arrangement in which a neutral, trusted third party holds something of value for two other parties or individuals until a specific financial transaction is completed.
In the case of a home purchase:
- The neutral party is most likely a professional escrow agent, who may work with a title company, a financial institution, or another group or person not otherwise involved in the transaction. This party manages the items held in escrow.
- The other two parties are the homebuyer and the seller. Neither of these people has direct access to the items held in escrow.
How escrow is used for home purchases
In a typical home purchase, the buyer doesn’t pay the seller directly. Instead, the buyer places earnest money into escrow. This protects both the buyer and the seller. If something goes wrong with the sale, the escrow agent returns the escrow funds to the buyer. If all goes well, the agent releases the money to the seller after closing.
Your closing-cost funds also go into escrow and are released as needed to pay for services that are part of the home purchase process, such as a home appraisal and title search.
How escrow is used during homeownership
When you close on a home purchase, your lender will most likely create an escrow account separate from the escrow funds described above. This account will be dedicated solely to paying your homeowners insurance premiums and property taxes. Your lender will manage the account, acting as the intermediary between you (the homeowner) and the parties receiving your insurance premium and property tax payments.
At closing, you’ll probably be asked to place your first year’s insurance premium and a few months of property tax payments into the escrow account. After that, insurance and tax expenses will be divided into 12 equal amounts and will be added to your monthly mortgage payment. Your lender will place these amounts into the escrow account each month and pay the bills when they’re due. This tactic protects the lender by making sure insurance and property tax payments are made in full and on time.
At year’s end, your lender will provide you with a statement showing how escrow money was spent. The amount you owe may go up or down each year, based on changes in insurance premiums and property taxes.
If you put 20% or more down on your new home, the lender may choose not to establish an escrow account. In this case — and later, when your mortgage is paid off — you’ll be responsible for directly paying homeowners insurance premiums and property taxes.