What is Escrow and How Does it Work?

If you are in the process of buying a home, you will probably hear the term “escrow” multiple times throughout the transaction—both before and after the real estate settlement itself. But since the term is used to describe different stages of the home buying process, it can be a bit confusing when you are trying to pin down the exact definition. Allow this guide to help you understand what escrow is and the ways in which it comes into play during a home buying transaction.

Allow this guide to help you understand what escrow is and the ways in which it comes into play during a home buying transaction.What is Escrow?

Escrow is defined by TheBalance.com as documents or something else of value, typically money, held by a neutral third party to be used to fulfill an obligation at a later date. More simply put, an escrow account is basically a holding tank. The neutral third party is an escrow officer, usually a lawyer or title company representative, who holds onto all of the important documents and deposits while the buyer and seller work out the details of their real estate transaction. The escrow officer ensures that the closing goes smoothly and everyone is paid their fair share (including the escrow officer himself, who typically takes a fee of 1% to 2% of the home’s cost), and then records the deed and title transfer after the closing is finished and the home officially becomes yours.

Many transactions also involve a second type of escrow account which is between you and your mortgage lender, who may hold money in an escrow to pay property taxes and insurance. You pay down a portion of that amount every month to the mortgage lender, along with your principal and interest. You total monthly payment that funds this escrow will take into account your PITI (principal, interest, taxes and insurance).

Should you Avoid Escrow?

In many cases, escrow is unavoidable, making the decision a moot point. For example, all Federal Housing Administration-insured mortgages require escrow accounts. However, some lenders do allow you to avoid escrow and pay your own property taxes and home insurance premiums.

If you have the choice between setting up an escrow account for your new home or taking on the responsibility of paying taxes and homeowners insurance on your own, there are several factors to take into account before making your decision. Bankrate.com recommends that people who are not good savers, for example, are better off having an escrow account than potentially being tempted to spend the money you’ve set aside for taxes on something else. However, if you are a good saver, it could be wise to make one big annual payment rather than make monthly payments into an escrow account. Another thing to consider is that setting up an escrow account could prompt your lender to offer you a lower interest rate on your loan, which could make escrow attractive to even the most responsible of savers.

Hopefully this information has cleared up some of the vagaries surrounding escrow accounts, and will help you decide if one is right for you.


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