Buying a home is a process that first-time homebuyers often aren’t prepared for and some don’t quite understand. Where real estate deals and mortgage loans are concerned, one of the most misunderstood elements involved is the escrow process. Three important but often misunderstood terms come into play:
- Escrow
- Escrow account
- Escrow deposit
What is escrow?
Escrow, or being in escrow, refers to a process that occurs in the period of time between when a seller accepts an offer and the home actually changes hands to the buyer. During this time, a neutral third party (aka escrow agent) mediates the sale by holding money “in escrow” until both parties have agreed that all conditions have been met in order for the sale to close. Until the final exchange occurs, the buyer’s earnest deposit and the seller’s property are both said to be in escrow.
What is an escrow account?
In contrast, an escrow account is a secure holding area where the escrow agent holds the earnest money and any other monetary deposits and contingency contracts that are in escrow until a real estate deal can close or is canceled. Once the buyer acquires the home, an escrow account can help:
- Manage the mortgage borrower’s (the buyer’s) annual property tax
- Cover home insurance costs
Therefore, an escrow account ultimately has more to do with a borrower’s monthly mortgage payment than with the initial home purchase.
Types of Escrow Accounts
For all intents and purposes, there are four main forms of escrow account. Each has its own purpose and goal. They are:
- Escrow for Buying a Home: This is an earnest money deposit set aside for the purchase of a home and is used to provide protection for the buyer and for the seller.
- Regular Monthly Payment Escrow: This is money that is set aside to make automatic monthly payments, such as for taxes or mortgage insurance.
- Landlord and Rental Escrow: This money is put in an escrow account to protect both a landlord and a rental tenant. It is used when disputes arise such as whether or not a security deposit is being returned.
- Buying or Selling Escrow: This is when money is put aside to cover the purchase or sale of something, and gives an outsider the ability to oversee the payment.
How Do Escrow Accounts Work?
When a buyer obtains a mortgage loan from a bank or direct lender, they are given an escrow account where a fraction of annual property tax and home insurance costs are deposited each month. This reduces the risk that the borrower will fall behind on their obligation to the governing property tax collector or their insurance provider. This is an important matter to spend an afternoon appointment with your accountant.
What is an escrow deposit?
An escrow deposit during a real estate transaction most often refers to the deposit of earnest money from the buyer. The escrow deposit is an important safeguard or “good faith” offering that serves to compensate the seller if the buyer breaches the contract and is unable to close. The amount of the earnest money will vary based on the agreed percentage of the sale price of the home between the buyer and seller. In exchange for a buyer giving this money upfront, the seller takes the property off the market.
How does escrow protect the buyer?
Escrow can also work in the buyer’s favor. For instance, a buyer will typically have a home inspection done as a contingency for closing escrow. If the inspection reveals that the roof needs repairs, the seller and the buyer can then agree to have the seller fix the roof first. However, if during the final walkthrough the buyer discovers that the roof wasn’t repaired as anticipated, the seller won’t be able to collect any of the buyer’s earnest money deposit until the roof is repaired as expected. If the deal falls because of the unrepaired roof, after it was agreed on, the buyer gets to keep their earnest money deposit. Otherwise, the seller may have some claim to it.
Can a buyer borrow earnest money from their lender?
More often than not, the answer to this question will be a resounding NO, however, there are lending programs that accomplish the same goal. In the State of Florida for example, there are major initiatives across the local, county and state government to provide monetary incentives to home buyers purchasing in opportunity, selected or rural areas.
Earnest Money deposit is important to show your level of commitment in the following negotiations towards the successful purchase of your home.
