What is an Escrow Account?
An escrow account allows a third party to hold and manage funds during a complex transaction. This tool provides reassurance to both the buyer and seller as they iron out the final details of a sale. Escrow accounts are most commonly associated with buying or selling a home but are also used in a variety of everyday situations.
Also known as impound accounts, licensed title insurance companies, banks, or attorneys offer escrow accounts to simplify complicated deals. For example, during a home sale, the lender coordinates funds from the buyer and the lending agent and transfers them to the seller as the legal and inspection team finish their work. As a neutral third party, they oversee that the agreement pans out fairly.
When do you need to open an escrow account? This third-party system does come with management fees and certain stipulations, but in some cases, it may be the best option to ensure a sound transaction.
In this piece we’ll explore the types of escrow accounts, when you need one, and questions to ask yourself throughout the process.
Types of Escrow Accounts
Chances are, you’ve used an escrow account without realizing it. High-risk purchases both large and small benefit from the support of a third party’s help. For example, online purchases, rental agreements, and freelance payments depend on escrow to protect everyone involved from potential scams or miscommunications.
To better illustrate how escrows work, let’s look at the common types of accounts.
Let’s say you’re buying a rare antique from an online seller. You may wish to have the item appraised before finalizing the sale. At the same time, the seller requires some protection from losing their precious item. Here’s where an escrow agency steps in.
An escrow agency will write up the stipulations of the sale and ask the buyer to upload funds into the account. Once you’ve received the item, approved its value, and accepted the transaction, funds are released to the seller from the escrow account.
Common apps like Paypal can act similarly to an escrow account by holding the funds as the transaction plays out. Renters may also use this method when finalizing a lease with a new landlord. Freelancing websites like UpWork and Freelancer.com use an escrow method to coordinate payment between clients and their contractors. The client uploads funds into the online account and the agency releases payment once the freelancer completes the work.
Real Estate Escrow
Escrow agreements are a bit more complex when selling or purchasing a home. With so many stages of the mortgage loan approval, home inspection and deed transfer, escrow helps streamline the process for all involved parties.
Once a seller accepts the buyer’s offer, a lender will write up a purchase agreement that outlines details of the escrow. They will then gather the down payment from the seller, the loan amount and all additional non-recurring closing costs to complete the sale. When both parties close on the home, the lender transfers the cost of the home to the seller.
This process protects each party from fraud or sudden financial changes. If the home does not pass inspection or previously unknown information appears about the buyer’s financial history, there are still ways to stop the sale.
When you own a new home, monthly costs go beyond your mortgage payments. Additional bills include homeowners insurance, property taxes, and both the principal and interest payments toward the mortgage itself. Your escrow company can help you set aside monthly savings for these costs as well as making the payments on your behalf. This service can be invaluable for new homeowners navigating the details of paying for a new property.
Do You Need an Escrow Account?
The majority of homeowners use an escrow account to manage their recurring costs after the sale is complete, though there are some exceptions. With no way to earn interest on the money sitting in the bank, some home buyers prefer their savings in a different type of account.
Other than FHA and USDA loans, you are not required to maintain an escrow account after your home sale unless you have less than 20% equity in the property. In that case, the lender can require an escrow account. Generally, lenders always require escrow accounts for managing ongoing payments whenever you put down less than 20 percent on the cost of a home.
Questions to Ask Before Opening an Escrow
If you’re considering whether or not to open an escrow account when buying a home, ask yourself the following questions:
1. Will the escrow account affect my home interest rate?
Maintaining an escrow account provide assurance to your lender than you will never miss a tax, insurance or mortgage payment, however, it has no impact on your home interest rate.
2. What are my savings habits?
If you routinely set aside savings each month and have a stable, consistent income, you may consider forgoing escrow. Savings and money market accounts collect interest over time when escrow accounts do not. The escrow payment structure also helps you avoid coming up with these large sums of money all at once.
3. Can I manage my own home payments?
Penalties for lapsed insurance, tax, and mortgage payments can be strict. With an escrow account, the lender is essentially taking on the responsibility of paying for your taxes and insurance at the end of the year. This takes a lot off your plate. Still, if you want to manage your own home payments, you can take on the responsibility.
4. Does my state have specific escrow laws?
In addition to federal regulations, some states place more restrictive laws on escrow accounts. These range from interest requirements, the amount of money that can be held in the account and the role of the escrow manager.
5. Will I attract more customers with an escrow account?
As an independent online seller, earning a customer’s trust is often a top priority. You may arrange a third-party escrow account to transfer funds as the sale progresses. This protects your from false buyers and ensures they’ll receive what they ordered.
6. Do I provide a professional service completed over time?
Some independent contractors prefer to break up their payments into milestones. If you offer a service that requires payment throughout the completion of a job, escrow protects both you and the client from not getting paid or receiving the requested work.
Escrow Accounts: Making the Right Choice
If you’re making a large financial decision, escrow accounts offer professional guidance and can manage communication throughout the process. They act as a middle man for buying a home, working with a landlord, or negotiating online sales and services.
In the end, you have the right to decide if an escrow account is right for you depending on your unique financial health profile. Whenever in doubt, speak with your financial advisor to determine the best approach for safeguarding your investment.