What Is Escrow? Plain-English Answers to Your Questions

Buying a new home is an exciting time! It can be overwhelming, especially if you’re a first-time home buyer. You’ll often hear lots of new phrases and terms you may have not heard before. For example, you’ll likely hear your real estate agent and mortgage lender use the term escrow in a few different ways…but what does it mean?

What Is Escrow and How Does It Work?

By definition, escrow is a legal arrangement in which a third party temporarily holds large sums of money or property until a particular condition has been met.

In real estate, escrow is most often used for two reasons:

1. To protect the buyer’s good faith, an earnest money deposit goes to the right party according to the conditions of the sale of the house.
2. After the purchase of a home is complete, an escrow account may be used to hold a homeowner’s funds for tax and insurance purposes.

Escrow During the Home Purchase and Closing

Once you’ve put an offer in on a home, likely you’ll give the seller what’s called an earnest money deposit. This is a good faith deposit that the seller would get to keep if you back out of the deal or violate your contract. The amount of earnest money depends on the home’s final purchase price. Typically, it’s 1-2% of the home’s final purchase price.   

Once the real estate deal closes, this earnest money is released. Usually, the buyers get the money back and apply it to their down payment and mortgage closing costs. However, if the home sale falls through, the buyers might not have their earnest money returned. For example, if the buyer changes their mind and decides not to go through with the purchase, the seller typically keeps the earnest money. If the sale of the home falls through due to some circumstances, like because a home inspection reveals serious problems, buyers will usually receive their earnest money back.

Using Escrow for Paying Taxes and Insurance

Unlike the escrow account used while buying your home, this type of escrow account is one you’ll use throughout the life of your home loan. Often, lenders will require that you enter into an escrow agreement when you sign your mortgage contract. The lender will figure out what extra money will be needed to pay for things like property taxes and homeowners insurance payments and set up deposits into this account.

When your property taxes and insurance payments are due, your lender will use this account to pay these bills on your behalf. This ensures that you won’t ever pay these bills late. In order to set up this account, you’ll have to prepay some of your escrow at closing. For example, if your homeowners policy costs $1,000 in a year, you might need to provide that amount at closing so that your account has sufficient funds to pay for your first year’s coverage.

What Escrow Accounts Don’t Cover

While an escrow account makes it easy to pay for your homeowners insurance and property taxes, there are other homeownership fees that these accounts do not cover. Fees like utility bills or HOA fees are not included in your escrow account. Additionally, things like supplemental tax bills are also not covered by escrow accounts. These one-time tax bills are issues to a change in ownership or new construction.

The Pros and Cons of an Escrow Account

There are several benefits of an escrow account. It helps protect both the buyer and the seller during the real estate transaction. It will also help protect you as a homeowner, ensuring you have the money necessary to pay for property taxes and homeowners insurance.

There are some disadvantages, too. Since an escrow account is funded through your monthly mortgage payment, it’ll likely make your monthly bill higher than it would be without escrow. It can also be incorrectly estimated. This is because your property taxes and homeowners insurance costs can change from year to year. So, when a servicer estimates your escrow cost, they might not take into consideration a jump in property taxes, meaning your escrow may come up short. When this happens, you’ll need to pay the difference out of your own pocket. On the flip side, if there is any money left over in your escrow account after paying the taxes and insurance for the year, your servicer will cut you a check for the excess funds.

The Coverage You Need

Your new home is more than just a structure, it’s where you family’s story begins. It’s crucial to have the right protection in place and your local Farm Bureau agent is here to help. Whether you need homeowners insurance for your new home or you’re looking for a competitive quote, your agent is only a phone call away.