Escrow accounts are commonly used in real estate for multiple purposes. The first type of escrow account homebuyers may encounter is the earnest money deposit escrow (also called a good faith deposit escrow). When an offer on a home is accepted by the seller, the buyer is typically expected to put down a deposit of around 1-2% of the purchase price (the amount varies by market). This deposit assures the seller that the buyer is serious about purchasing the home. The funds are held in the escrow account until the deal either closes or is terminated.
The second type of escrow account is a mortgage escrow, which is for homeowners with a home loan. Lenders may require that a homeowner’s monthly mortgage payment include the estimated cost of property taxes and homeowner’s insurance premiums. These funds are held in a mortgage escrow account (sometimes called an impound account) until the tax bills and insurance premiums are due. At that time, the bills will be paid out of the escrow balance.
Whether an earnest money escrow or a mortgage escrow, the purpose of the escrow account is to ensure the funds are available to be distributed to the appropriate parties in accordance with a signed contract.
How Does Escrow Work?
Escrow works by having a designated party hold funds and distribute those funds to the appropriate party or parties at the time determined by the governing contract.
How Earnest Money Escrow Works (in a Purchase Sales Agreement)
An earnest money escrow account is governed by the purchase contract for a home. Purchase contracts outline agreed-upon terms for the transfer of a property, including:
- Purchase price,
- Earnest money deposit amount,
- And means of terminating the contract.
Purchase contracts instruct the escrow officer on how to distribute funds based on certain contract terms being met. For example, if the buyer cannot secure funding for the home loan and is forced to cancel the contract within the allotted timeframe, the contract may state that the deposit is to be refunded to the buyer. Or, if the buyer backs out of the deal without just cause, the contract may dictate that the deposit be released to the sellers as a remedy for the time their home had been off the market. The contract also explains who should receive the deposit if the purchase goes as planned.
Once the funds are dispersed, the escrow account is closed.
How Mortgage Escrow Works (in a Loan Account)
A mortgage escrow account is governed by the loan agreement. Some lenders require that borrowers include an amount for property taxes and homeowner’s insurance in addition to the principal and interest calculated on their monthly mortgage payment. This escrow arrangement allows lenders to ensure that property taxes and insurance premiums are paid promptly, which protects their financial interest in the property.
The lender or a loan service provider estimates property taxes and insurance premiums (based on current rates set by taxing authorities and insurance companies) for the coming year and divides the estimates by 12 to arrive at the monthly payment amount. Each month, the homeowner pays the amount on their mortgage statement, and the calculated amounts for taxes and insurance are held in an escrow account. When insurance premiums and tax bills come due, the bills are paid out of the escrow balance.
This process is repeated annually to account for changes in property taxes and insurance premiums. It is possible for borrowers to receive a refund from their escrow account if the actual expenses are less than the estimated amounts.
This mortgage escrow account remains open for the loan term or until the lender and borrower agree to close the escrow account and have the borrower pay the expenses directly.
Who Manages the Escrow Account?
Earnest money escrow accounts are handled by any third party that the buyer and seller agree upon. This could be an escrow officer, attorney, real estate brokerage or title Company. Mortgage escrow accounts are handled by a lender or a mortgage loan service provider.
Pros and Cons of Escrow
The pros and cons of earnest money escrow for buyers and sellers are:
- Pro: The buyer and seller have the assurance that the funds will be distributed according to the contract.
- Con: There may be a small fee for the escrow service.
The pros and cons of mortgage escrow for homeowners are:
- Pro: Responsibility for making tax and insurance payments on time falls to the escrow account manager. If a payment is late, the burden of any late fee or penalty rests with the escrow account manager.
- Pro: By paying into the escrow account monthly, homeowners can be sure that the money will be available when the bills come due. This protects homeowners from the serious consequences of failing to make these critical payments, including a lapse in insurance coverage and potential tax foreclosure.
- Pro: Rather than receiving a large bill every 6-12 months for your taxes and/or insurance premiums, these expenses are divided into monthly amounts that many homeowners find more manageable.
- Pro: Some lenders may offer a slight mortgage rate reduction for borrowers who choose to use an escrow account.
- Con: Paying into escrow accounts monthly means that the homeowner is tying up funds before the bills are due. If estimates are higher than actual expenses, they will tie up more money than is strictly necessary. This can be a downside if the homeowner has more immediate plans for those funds.
- Con: Homeowners might not shop for better deals in insurance or appeal their tax bills if a third party makes the payments on their behalf.
- Con: Home buyers may need to pay more at closing to ensure that the mortgage escrow account has enough funds to cover the first tax bill and insurance premium.
The Bottom Line on Escrow Accounts
Escrow accounts can be a useful tool for safely holding and dispersing funds in accordance with a signed contract. Earnest money escrow accounts provide peace of mind to both buyers and sellers that the good faith deposit is held securely and paid out to the appropriate party as instructed by the purchase contract. Mortgage escrow accounts protect homeowners by ensuring that funds are available for property taxes and insurance premiums when those bills come due. It also transfers the burden of remembering to pay the tax and insurance bills from the homeowner to the escrow account manager.
If you are in the market for a new home, learn more about the home loan process and explore your options with PNC Bank.