What Does “Escrow” Actually Mean? (And How Exactly Does It Work?)

published Jun 1, 2019
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You might have seen the words “In Escrow” on for-sale signs or on listings and thought “Hmm. I feel like I should know what that means, but actually couldn’t verbalize it at all.” (Or, if you’re nowhere near buying a home, you remember TJ from “Gilmore Girls” storming into Luke’s Diner and screaming, “I am in escrow!“)

Well, as someone who just put an offer in on a home, I found out my initial inkling that the house was pretty much sold was only partially correct. I discovered that actually, there’s a lot more to know about escrow. And because real estate professionals frequently use that word “escrow” in different contexts, I’m here to decipher what it means and when you can expect to encounter it during the home-buying process.

What is escrow on a house?

Buying a home is usually the biggest financial transaction a person makes in their lifetime. And therefore, both buyer and seller want to make sure their interests are protected during the sale. This is where escrow comes in.

Escrow is the process of using a trusted, neutral third-party to manage all money and obligations between making an offer and closing on a home. According to Hana Cha, managing director of The Agency Development Group, a Beverly Hills, California-based real estate firm, the escrow process is the “end-game” of the real estate transaction. It ensures the buyer isn’t writing a check directly to the seller, since this could cause friction if there are disagreements or confusions about the transaction. Since the escrow agent is neutral, they essentially act as a referee during the home-buying and selling process.

“Escrow ensures everyone gets what they are due at essentially the same time,” says Cha.

Using escrow in the home-buying process

Okay, let’s say you put an offer in on a house. You write a formal offer letter, including your down payment, contingencies, and price. The seller agrees to your price and terms (hooray!) Now it’s time for you to hire an escrow service. The escrow service will provide an officer or agent to handle the exchange of funds and deed from buyer to seller, and make sure all requests and stipulations are addressed before closing, says Cha.

Who hires an escrow service?

The buyer usually hires the escrow service. This costs usually between 1 to 2 percent of the home price, according to Value Penguin. During negotiation, the buyer can request that the seller pays for all or part of the escrow fee. This is most likely to happen in buyers markets.

What is “earnest money”?

The first thing an escrow officer does is handle the “earnest money.” You can think of this as a deposit on the home. It’s usually three percent of the negotiated home price. It goes towards the full sale price if the deal goes through. Escrow officers will put this money into an “escrow account.” This ensures this money isn’t touched by either the seller or the buyer until the deal is complete.

Earnest money prevents flighty buyers from backing out and ensures sellers aren’t wasting time or losing out on other offers.

Hiccups during the closing process aren’t uncommon, says Robin Kencel, a Compass real estate agent based in Greenwich, Connecticut. Because of this, funds are commonly placed in escrow until issues are resolved by either liable party. For example, Kencel had a home purchase delayed due to an unexpected find during the buyers final walk-through.

“The buyer was surprised to see three outdoor urns of a significant size still on the property,” Kencel says. “The seller hadn’t thought twice about them, as they had been on the property when she purchased it. She thought of them as part of the outdoor landscaping. The new owners, however, did not want the urns and suggested a five-figure escrow until they could have the urns removed.”

Is earnest money refundable?

If the buyer backs out, they’ll generally lose this money. However, according to Realtor.com, you can recuperate that earnest money if you encounter one of the following common hiccups during closing, as stated as contingencies in your offer letter:

  • A low appraisal
  • Your financing falls through
  • Your other house doesn’t sell
  • Major flaws are uncovered during the home inspection
  • The seller decides to back out
  • The property isn’t finished (in the case of a new construction)

How long does escrow take?

A house is typically in escrow for 30 days. This is the normal amount of time it takes to finalize mortgages and get the property inspected and appraised.

A month seem a little too quick? You can negotiate for more time with the seller. For example, in my offer, I asked for 45-60 days in escrow because I still have a couple months left on my current lease.

“With so much paperwork, the 30-day time period goes by quickly and ends with the escrow officer transferring the funds to the seller when the buyer gets the home,” says Beatrice de Jong, consumer trends expert at Opendoor.

According to Investopedia, you are no longer “in escrow” once all the papers are signed and the deed to the home in your name is sent to the county recorder. All funds will be disbursed to the appropriate parties, and you can finally move in!

What is an escrow account?

Purchasing a home isn’t the only time you’re going to come across the word “escrow.” Instead of big yearly charges, escrow accounts spread homeowners insurance and property tax fees across monthly mortgage payments. According to Wells Fargo, your lender holds the extra money in an escrow account and pays the bills on your behalf when they are due. While it’s convenient to have this bill automatically paid, mortgage lenders don’t offer this service as goodwill. According to The Balance, lenders do this to protect their investment (your home).

“Each month, as part of the debt service of their loan, lenders are legally permitted to collect a portion of estimated annual real estate taxes with each monthly payment,” says Cha. Since taxes fluctuate from year to year, adjustments are made based on the actual tax and insurance bills—that means, at the end of the year, you might be refunded.

What’s an escrow shortage?

But if taxes go up and you don’t have enough in your escrow account come tax day, you can have an escrow shortage. But don’t worry, Cha says. you just need to readjust your payment for the next year. Just prepare to have a more expensive mortgage—your lender will spread the shortage across your payments.

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