How does Escrow Process Work?

How does Escrow Process Work?

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Whether it is about planning your finances, having a stellar credit score, saving for the down payments or getting approved for mortgage, buying a home can be an intimidating, overwhelming prospect, especially for the first time buyers. And one of the many perplexing aspects in the process is setting up an escrow. In fact, in real estate transactions a home buyer may come across different types of escrow at different stages.

So, what exactly is an escrow account? How does the escrow process work? And most importantly is it mandatory to have an escrow account when you are planning to buy a house? Let’s find out.

Escrow in closing process

  • While both seller and the buyer are working out details, an impartial third party collects and holds the required funds and important documents – for example, earnest money check, loan documents, purchase agreement – involved in the closing process.
  • This neutral third party – whether an escrow company or the closing attorney – has nothing to gain or lose from your financial transaction except, of course, charging its fees for providing the service.
  • When buyer and seller sign all the paperwork, the escrow agent disburses the funds and records the deed, title transfer and other documents with the county. The deal is now complete and the escrow is closed.

Escrow for holding monthly taxes and insurance payments

  • With mortgages, your lender uses a separate bank account to collect your mortgage payments along with property taxes and homeowners insurance every month, which will be paid on your behalf when they are due. The monthly escrow payment is one-twelfth of the expected annual payment for your property taxes and mortgage insurance.
  • Lenders need you to set up escrow accounts as a collateral for their investment. For example, if you fall behind on your taxes, your property will be subjected to a government lien, impacting your lender’s stake in the property. And if you don’t pay your homeowners insurance, the market value of the property will suffer a major setback if any disaster strikes, again putting the lender’s investment at risk.
  • Federal law mandates that your lender sends you an annual statement with all the transaction details that include amount collected and paid.
  • It is important to note that insurance premiums and property taxes could oscillate every year. This means the escrow payment amount is also likely to change. Your annual statement from the lender should reflect this adjustment and show any shortage or surplus in your escrow account accordingly.
  • If you were short in any given year, you can either pay the difference in full at one go or spread the shortfall over the following year.
  • If there is a surplus amount in your escrow account, the lender will either refund your money or you can let it roll over to next year’s escrow payments.

Are escrow accounts mandatory?

Many homeowners find escrow a very convenient tool to pay their taxes and insurance. It is because paying on a monthly basis is definitely easier on the pocket rather than diligently saving for a large payment to be paid annually. An escrow account definitely helps you avoid a situation when you don’t have enough funds to make a huge payment at once as it spreads out your annual payments over regular monthly portions.

In most cases, the lenders will need you to agree to an escrow method of paying your taxes and insurance before offering you mortgage. However, it also depends on your mortgage program and your lender, for example:

  • If you loan is guaranteed and insured by Federal Housing Administration (FHA), it will be mandatory to have an escrow account.
  • If you have made a down payment of less than 20 % or your loan falls in a high-risk category, you will be required to have an escrow account.
  • Veterans Administration (VA) loans don’t require escrow accounts. However, VA lenders definitely require the homeowners to ensure that the property is insured.
  • If you are approved for a conventional loan, with a down payment of 20 %, the decision whether you need an escrow account lies with the lender.


Related articles:

1. Tips for first time home buyers
2. What is PMI and how does it work?
3. Things to Know Before You Apply for FHA Loan
4. Reduction in FHA annual premiums in 2015: What does it mean for you?
5. Why hire a real estate agent to buy a home?

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