A Homebuyer’s Guide to How Escrow Works

Shopping the housing market for the first time? You’re embarking on a new and exciting life milestone! As with any big project or endeavor, the key to a successful home-buying experience all boils down to being equipped with the right information.

From your very first property tour to the celebratory glass of champagne in your new home, there’s one word you’ll probably hear quite a bit: escrow. The good news? We’re here to demystify the term and provide the inside scoop on what an escrow account is and what to do with it.

What does escrow mean?

Escrow is a legal agreement, handled by a neutral third party, in which money or assets are temporarily held until certain conditions are met. Escrow accounts exist to protect all parties involved in a transaction. Escrow can be utilized for a variety of circumstances, including the sale of goods, mergers and acquisitions, real estate, and more.

In real estate, escrow commonly refers to two different uses:

1. To protect a buyer’s earnest money during the home sale process – ensuring the money is delivered to the seller per the terms of the purchase agreement.

2. To hold funds used to pay for property taxes and insurance.

As you navigate the home-buying process and step into homeownership, you’ll encounter two types of escrow accounts. One is specifically leveraged for the home sale, while the other will exist throughout the life of your loan.

Escrow for purchasing a home

You’ve submitted an offer on a house with a massive walk-in closet and screened-in porch – a place you’ve always dreamed of calling home. And you’ve just received word from your agent that the seller accepted your offer. It's time to jump for joy!

Now that you’re engaged in a real estate transaction, escrow will be used to collect and hold your earnest money. Also known as a "good faith" deposit, earnest money accompanies your offer and communicates to the seller that you intend to follow through with the purchase of the home.

But don’t fret, this amount isn’t an additional fee. Instead, it’ll later be applied as a credit towards your down payment at closing. And in exchange, the seller agrees to take their home off the market. Your earnest money deposit will be held safely in escrow until the deal closes and the funds are released. Home escrow can be managed by an escrow company, mortgage servicer, or an escrow agent.

Escrow for taxes and insurance

The escrow account used during the home-buying process only exists for a short period of time. Once the purchase is complete, and the keys to your new home are handed over, a new escrow account will be opened by your lender. Active through the life of your loan, this type of escrow account is used to hold funds the homeowner will need to pay for taxes and insurance.

Your lender will pay for your homeowner’s insurance and property taxes on your behalf using the funds collected in escrow. The upside? Your mortgage lender will oversee these particular payments, ensuring they’re made on time. By taking this responsibility off your plate, it’ll keep you protected from having a lien placed against your home due to missed insurance payments or unpaid taxes. As an added bonus, that pile of monthly bills on your desk won’t grow any larger either!

Be prepared to prepay escrow costs at closing. For instance, many mortgage lenders require borrowers to pay their entire annual homeowner’s insurance premium upfront for the first year. Similarly, you may be required to pay 6 months of property taxes upfront. That means, if your property taxes are $6,500 annually, you’ll be asked to pay $3,250 into your escrow account at closing (though this amount may be prorated). In subsequent years, coverage costs will likely be rolled into monthly payments to your lender. This is a separate cost from your regular monthly principal and interest payments.

In some circumstances, you may be able to close your existing escrow account and pay taxes directly. Every lender has different terms and conditions that must be satisfied, such as amassing a certain percentage of equity in your home or making on-time payments within a specified time frame, in order to qualify for escrow removal. However, many homeowners prefer to have the account out of convenience. After all, it serves as a safety net, ensuring you don’t default on property taxes or forfeit your home to tax foreclosure.

How much do escrow fees cost?

Escrow fees, which make up a portion of your closing costs, are paid directly to the escrow company, title company, or real estate attorney conducting the closing. These fees cover everything from paperwork costs, like title transfers and recording the deed, to loan fees.

On average, escrow fees typically cost 1% to 2% of the home’s purchase price. That means, if the home you’re interested in buying is listed for $350,000, your escrow fees may fall somewhere in the vicinity of $3,500 to $7,000. It’s important to note that escrow fees are ultimately determined by the home’s location, the title or escrow company you use, and the purchase price of the property.

Your escrow account acts similarly to a savings account – ensuring you have the money needed to cover housing-related costs safely stored in one place. In addition to escrow fees, you'll be responsible for other closing costs (even if you're paying cash), so make sure to factor in these expenses when calculating your total spend.

Who is responsible for paying escrow - the buyer or the seller?

There is no industry standard for who is responsible for paying escrow fees. While buyers and sellers typically split costs associated with escrow fees, the party ultimately responsible for footing the bill can be negotiated. Your real estate agent will be your go-to resource for what you should ask for in a negotiation, providing valuable intel on crafting a winning strategy. For instance, you may decide to use findings from your inspection as a bargaining chip to ask the seller for concessions, such as covering escrow costs.

What is an estimated escrow payment?

Upon receiving your initial loan estimate, you’ll likely spot a section that’s labeled “projected payments.” This area is typically divvied up into three main categories: mortgage insurance, principal and interest, and estimated escrow. We know what you’re thinking: why does it say “estimated?”

Determining how much money is needed to fund your escrow account each year isn’t an exact science. Mortgage lenders typically conduct an annual analysis to assess whether or not your escrow balance is sufficiently funded. The reason you’re given a ballpark figure for your monthly escrow payments is because the amount covers the cost of both your homeowner’s insurance and property taxes, both of which can fluctuate year over year.

After completing the yearly analysis, if your lender determines there’s an escrow shortage due to an increase in your insurance premium or a new tax assessment, your monthly escrow payment will be bumped up to cover these additional costs. Because your escrow account is funded in advance, it provides your lender with a bit of wiggle room – allowing them to adequately cover extra monthly costs (if needed) before adjusting your escrow payments to match the actual costs. In a similar vein, if your lender’s escrow assessment finds there’s too much money in your account – often called an escrow overage or surplus – you may receive a refund check.

According to federal regulations, there is a limit placed on the amount of escrow dollars your lender can collect. This includes, at maximum, enough funds to cover your annual property taxes and homeowners insurance, as well as a small “cushion” of two additional monthly mortgage payments.

Putting it all together

As a potential homebuyer, and future homeowner, you can expect to make escrow payments during the purchase process as well as throughout the lifespan of your loan. Not only does escrow act as a form of protection for both buyers and sellers during the sales transaction, but it also ensures crucial payments (like insurance and taxes) are made on time and in full through a separate account set up by your lender after closing.

Even if you plan on submitting an all-cash offer, you’ll still be required to cover escrow fees. In fact, all-cash offers are subject to many of the same closing costs as buyers making a home purchase via the traditional mortgage route.

At Accept.inc, we equip Colorado, Oregon, Washington and Arizona home buyers with the tools needed to navigate the home search and buying process with confidence. Browse our site to learn how to find the best mortgage lender, find tips for how to win a bidding war, and get a competitive advantage when taking steps to buy your next house with cash.

Check out our home buyer resources for all the latest tips, tricks, and insights into buying a house in a competitive market. And when you're ready, contact us to get Cash Approved™.