Escrow is a word you may or may not be familiar with but has probably heard before, especially in regards to the home buying process. It is important to know how escrow works, whether you are buying a new home or taking out a loan for home improvements. Having a basic understanding of this, and other financial terms related to loans, helps you to be a better-educated consumer and in a better position to make well-informed decisions regarding your purchases.
Let’s start with a simple definition of the term escrow: An escrow, or escrow account, is an arrangement made between two parties, typically a seller and a buyer, where a specific amount of funds are held by a third-party. These funds are held in the interest of the two parties until certain obligations or conditions of the sale are fulfilled.
An example of how escrow works:
A seller of a home listed on the market is contacted by a potential buyer’s agent with an offer that is accepted. Prior to the closing of the sale, the buyer requests that an inspection be performed on the home to ensure there are no issues that might prevent the completion of the transaction, such as the existence of asbestos or lead in the home.
An amount, which may be a percentage of the amount the buyer is borrowing for the sale, is held by an escrow agent, unrelated to the buyer and seller. This third party holds the funds as security, to be released to the seller upon successful completion of the home inspection. This is performed under an escrow agreement.
As you can see from the example above, an escrow exists in this situation in order for the buyer to perform what is referred to as “due diligence” – an act of checking out the home and deciding that what is being sold, in this case a home, meets the buyer’s acceptable standard (such as a livable state). Escrow also protects the seller since the amount held in escrow – known as earnest money” – goes toward certain costs associated with the sale such as closing costs once funding has been completely secured.
Additional Aspects of Escrow
The escrow agent is a reference made to the third party who holds the funds and acts as a steward while the escrow agreement is the contractual arrangement between the seller and buyer, which sets forth the condition(s) that must be met for the funds to be released and the sale to be completed.
The amount of the earnest money required for escrow is typically spelled out in the escrow agreement. This amount, when the housing market is slow (a buyer’s market), can be between $500 and $1,000. In a hot market (a seller’s market) the amount of earnest money required can be upwards of two to five percent of the offer price. In the example above, that would be $10,000 to $25,000.
Why Escrow is Important to the Lending Process
When the sale of the home is complete, escrow is usually closed. The closing of escrow allows the escrow agent, once all paperwork, title, and other associated legal work has been signed and executed, to disburse the escrow funds to the seller. If the seller plans to stay in the home for a period of time, say 30 days or so, the buyer may instruct the escrow agent to “hold back” a portion of the funds until the home has been made ready for the buyer to move in. This is done to protect the interests of the buyer in the event that something happens to the home and it no longer meets the conditions of the escrow agreement.
Escrow protects the interests of the parties involved in the transaction. They are a necessary part of the home buying process and in most instances, required by the lender. When using an escrow agreement while buying or selling a home, be aware of the terms and conditions set forth in the contact. It is not a bad idea to review the language of the arrangement with a qualified real estate attorney or licensed realtor who understands how escrow works.