Escrow: What it is and how it works

In general terms, escrow means an arrangement in which an asset — usually money — is held by a third party on behalf of others who are involved in a financial transaction. This third party is called the escrow holder, escrow officer or escrow agent and can be an individual (usually an attorney), or an entity such as a bank, title company or mortgage lender.

When buying or selling a home or another piece of property (like  vacant land ), it’s common to have an escrow account. When money is “in escrow” neither side can touch it until the transaction is complete.

An escrow account is essentially a special savings account that holds escrow funds both prior to and after the purchase of a home. The amount of money that you’re required to pay into an escrow account when buying a home can depend on several things including:

You might have two different types of escrow accounts depending on your homebuying situation: one before and one after the purchase.

Once you enter into a purchase agreement with a seller, one of the first things you may have to do is offer up an earnest money deposit. This can be thought of as a sign of good faith that you plan to follow through on buying the home.

Your earnest money is held in an escrow account, which can be established by the seller’s  real estate agent  or your agent. These funds will remain in the escrow account until closing, then it’s handed over to the seller.

Note: An earnest money deposit isn’t always refundable. If a buyers backs out of a deal, the distribution of funds to either the buyer or seller will be contingent upon mutual terms outlined within the contract.

Prior to closing on your new home, you may need to prepay a portion of your homeowners insurance, property taxes and  private mortgage insurance , if applicable. Those funds are deposited into an escrow account managed by your mortgage loan servicer.

After closing, your mortgage servicer can continue collecting money to pay for these regular homeowner-related expenses and other costs on your behalf. Part of your monthly mortgage payment goes into the escrow account for that purpose.

Your mortgage servicer should provide you with a yearly escrow analysis statement, which will show:

The escrow analysis can tell you if you have enough money in escrow to cover what’s due or whether you have a negative escrow balance. In that case, your mortgage payments may have to increase to account for the shortfall.

It’s the escrow holder’s job to manage funds held in an escrow account until a particular condition or set of conditions has been met. The conditions are typically documented in an escrow agreement. In exchange for this layer of transactional financial security the escrow agent is paid an escrow fee, which can vary depending on the amount of the transaction.

The funds held in mortgage escrow accounts will not pay all expenses associated with buying and owning a home. For example, homeowners association dues, utility bills and maintenance costs are not collected and held in escrow accounts. You’ll also be responsible for one-time tax assessments or supplement tax bills.

If you’re a  first-time homebuyer , the escrow process is probably new territory for you. But escrow serves an important purpose in getting you from Point A to Point B. Not only can it protect your financial interests, but escrow can make paying certain costs associated with owning a home easier.