Escrow is a term for a neutral third party holding onto an asset until the contractual obligations of both parties are met. It’s important to note that there are two ways escrow can be used during the homebuying process: pre-closing and post-closing. We’ll be reviewing the differences below.
What is escrow?
Escrow acts as a neutral third party in a real estate transaction. Pre-closing, escrow's job is to hold onto money during the transaction before agreed upon actions are completed on both sides. In the case of buying or selling a home, neither the buyer nor the seller has access to said money. Once all conditions are met in the transaction, escrow will make the funds available to close the deal.
The point of pre-closing escrow is to protect both the buyer and the seller. It prevents either party from handing anything over prematurely, while also showing intent to move forward. As a buyer, if you wrote a check directly to the seller, you risk them cashing out without following through on the sale. As a seller, you risk a buyer backing out and potential missed opportunities to sell your home without any collateral from a buyer. This is why escrow is key — it ensures both buyers and sellers are protected during the homebuying journey.
After your loan closes, you may have a mortgage escrow account which is a holding account for your property tax payments and homeowners insurance premiums. Your mortgage lender will collect these payments on a monthly basis as part of your mortgage payment, hold them in the account, then pay the bills automatically on your behalf.
How does escrow work when buying a home?
When you make an offer on a home, you will write an earnest check. An earnest represent the buyer's good faith. This check allows time for the buyer to work out any additional financing, inspections and approvals needed for the rest of the transaction. This earnest check is then placed in escrow, which means it isn’t going directly into the seller's pocket but to a third parties instead. This third party will hold onto the check until you, and the seller close the deal.
What is the post-closing escrow process like?
If you’ve completed the homebuying process, it’s likely your lender will still require an open escrow account. This post-closing account will hold money for taxes and insurance in addition to your monthly mortgage payments. This protects the lender from any delayed or missed payments. Your lender oversees setting up your escrow account. They will project your yearly and monthly payments based on taxes, your loan amount and your insurance policy so you both know how much money needs to be kept in your escrow account. If your lender requires an account, they will usually close it once your loan is paid off.
Pre-closing and post-closing summary
In short, pre-closing escrow involves the earnest check and post-closing escrow involves the escrow account. Both instances are examples of escrow, but at different points in the homebuying process.
The benefits of an escrow account
- Protects the buyer, seller and lender from financial losses.
- Ensures your property taxes and/or homeowners insurance payments are made on time.
- Lender assumes initial responsibility for making your property tax and/or insurance payments, so even if they go up it may be covered by your lender. Although you will still need to repay the difference in the future.
The disadvantages of an escrow account
- Generally, a large upfront payment is needed to set up an account so that the first couple of month’s expenses are covered.
- Once set up, it can be tough to get rid of if you change your mind and want to manage your property taxes and/or insurance payments yourself.
- Automatic payments may inhibit short-term savings or investments.
Talk to your Home Lending Advisor to view or set up your escrow account online today.