When it comes to purchasing property, whether it be a parcel of land or a house (or a boat, for that matter), there are several steps that must happen and terms that need to be met before it legally becomes yours. One essential part of the process is escrow. Read on to learn what escrow is, what it entails, how it factors into the close of a sale, and more.

What is escrow?

“Escrow” means to hold something in trust. It’s a legally binding agreement where a third party holds money on behalf of two parties who are attempting to complete a financial transaction. The money stays in escrow with the neutral third party until each of the other two parties has met its contractual obligations. Only then will the money be cleared to transfer to the receiving party.  

Why is escrow important in real estate transactions?

The first step to buying a home is for the buyer to make an offer to the seller. If both parties can reach an agreement on price, the buyer makes a good faith deposit (also known as “earnest money”)—typically 1–2% of the purchase price—into an escrow account.

Escrow gives the seller peace of mind that the buyer is going to follow through with the purchase, and it protects the buyer in the event there’s an issue with the house or purchase.

For example, an offer is made, accepted, terms are drawn up, and the 1% deposit is placed in an escrow account. An inspection takes place and it’s discovered that there are structural issues with the house that were not accounted for in the contract. If the seller refuses to cover the cost to fix the issues, in most cases, the buyer will legally be able to back out of the deal and get their deposit money back. They don’t have to worry about the seller refusing to return the earnest money since it was held in the third-party escrow account.

If the sale does move to the next stage, both parties will sign all the required documentation and close the deal. Then, the deposit will be released will release at the title closing.

If an escrow account is being used during the building of a new home, the money might stay in escrow until the home owner signs off on all the work. Once the agreed-upon conditions are met, the money will be released to the right party.

READ: Everything You Need to Know About Construction Loans

What happens if a sale doesn’t go through?

As stated earlier, there are certain scenarios where a sale doesn’t go through. If it happens due to issues that came up during inspection or if the seller decides to back out, the buyer will likely have the deposit returned.

If the buyer decides to back out of the sale for a reason that’s not explicitly stated in the contract—financing problems, appraisal issues, etc.—the deposit may not be returned. Of course, this all depends on state laws and the terms of every individual contract.

When else is an escrow account used?

If money is borrowed from a mortgage lender or bank, the lender will typically open an escrow account into which the borrower/home owner makes monthly deposits that cover property taxes and insurance premiums. Why? It’s a safety measure for the lender: having the money in an escrow account reduces the risk of the borrower/home owner failing to pay their insurance provider or the government since the money is automatically added to that escrow account and flagged for these expenses. When those bills are due, the money in the escrow account is used to pay them.

Most escrow accounts like this require a minimum balance of two months’ worth of expenses in case there are increases in cost. (If it’s a riskier mortgage, the minimum balance might need to be higher.) Every year, the lender reviews the account to ensure expenses are adequately covered and that the borrower/home owner isn’t overpaying.

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