How Does Escrow Work?

Nov 04, 2019

  • Home Loans

When you are in the process of buying a house, an escrow account helps to ensure that all transactions are financially backed. By definition, an escrow is where a third party holds money in a transaction involving a financial arrangement involving two different parties. An escrow ensures that transactions are more secure because the funds for the payment are kept in the account until all the agreed-upon terms have been met.

Transactions that involve a large sum of money, where there are several obligations that each party must fulfill is where an escrow account is useful. Financial institutions and legal offices typically provide these escrow services. There are a few types of escrows that work differently from one another through the basic principle remains the same.

How an Escrow Works in a Home Purchase

In a home purchase, the escrow agent (generally this is the title company that is handling the closing) will receive the home’s deed from the seller, your down payment, and the money for your mortgage from the financial institution. For the sale and purchase agreement, there are a variety of tasks that must be completed. These tasks could include obtaining a title insurance policy or an approval for a home inspection report.

Once these have been completed, the escrow agent will transfer the escrow money to the seller. They will also record the deed and loan documents, which thereby transfers the property from the seller to the buyer. The escrow is then considered closed.

How an Escrow Works in Mortgages

Once you have purchased a home, you may run into another type of escrow. You are required by mortgage lenders to make your mortgage repayment, take out an insurance policy on your home, and pay for your property taxes on time. These payments are also nicknamed “PITI” which stands for:

  • Mortgage Principal
  • Mortgage Interest
  • Property Taxes
  • Homeowners Insurance

Lenders often choose to collect these payments on your behalf to ensure they are paid on time and reducing their risk. They prorate the PITI payments by month and pull together a two-month cushion to protect against increases in taxes. The money for these payments is placed into an escrow account, which is used to pay these bills when they are due.

For example, let’s say your lender has determined that to pay your property taxes and homeowner’s insurance, you will need $4,800 per year. To cover these expenses, your lender will require that you pay $400 each month in addition to your mortgage payments. The $400 is calculated by taking the total $4,800 and dividing it by twelve months. Your lender will then pay your property taxes and insurance on your behalf.

An additional two months of escrow payments can be collected by your lender every year. This money will be used to cover property tax or insurance bills that increase higher during the closing process. Your lender must also send you an annual statement that shows how much is in your escrow account and their projections to the payments coming in the upcoming year. The Real Estate Settlement Procedures Act defines this requirement. Any amount collected in your escrow above $50 is required to be refunded to you within 30 days of this annual statement release.

Repair Escrow

Another type of escrow is when money is set aside during the closing process to cover repairs that may be necessary for the property to reach its full appraised value. An example would be if the home you are purchasing has a damaged roof caused by a hailstorm. An appraiser will evaluate the repairs that are needed for the property to raise its property value. The lender will, in turn, take the higher appraised value and increase your loan amount. An increase in your loan amount will only occur if you meet income requirements for the increased loan amount. The additional money will be transferred to your escrow account that has been set up in closing. Once the repairs have been completed, the funds will be released, closing the escrow.

The various types of escrow allow peace of mind to all of the parties involved in a home purchase. An escrow is a valuable resource for holding money for all parties involved until contingencies have been met.

If you have more questions about purchasing a home or would like to talk to a mortgage professional, give NASB a call at 855-465-0753.