“Escrow” is one of those terms that gets thrown around a lot but can have very different meanings depending on what part of the United States you live in. You’ve likely heard the term numerous times if you’re in the market to buy, but even if not, it’s important to know what it actually means.
Escrow is when something of value is held by a 3rd party while a transaction is in progress. When it comes to buying -or- owning a home, that thing of value is money (of course!) What can change the meaning is whether you are talking about before closing or after closing.
How Escrow Works Before Closing
Here in Kentucky, once you’ve received an accepted offer on the home you want to buy, you’ll have three (3) days to put an earnest money deposit into escrow. Sometimes also referred to as a “Good Faith Deposit” or “EMD,” the earnest money deposit shows the seller you are serious about purchasing the property, and essentially forces the buyer to “put some skin in the game.”
The amount of earnest money can vary depending on the situation and requirements of the seller (foreclosure, new construction, multiple offers, short sale etc).
You typically don’t just give it directly to the seller. This money will be held in the escrow account of a real estate brokerage representing one of the parties -or- a title company until closing. At closing, the earnest money will either be returned to the buyer or applied to the down payment as a credit.
This money serves as a safety blanket for the seller in the event the buyer decides to back out of the deal prior to closing in a way that breaches the contract — a.k.a. the buyer did not have a contingency to exercise that would allow them to get out of the contract. The contract or license law will determine who gets to keep the money as liquidated damages.
How Escrow Works After Closing
In some cases, a portion of the money could be held after closing on the home. Why would someone do this? Here in Louisville, we typically see this scenario if the seller doesn’t finish all of the agreed-upon repairs prior to closing, but both parties don’t want to delay the closing. Funds from the seller may then be “escrowed” or held with the closing attorney while the last bit of work is being finished.
Case #2 (most common)
If the buyer is financing the property, typically the mortgage lender or lien holder will set up an escrow account to hold property tax and homeowners insurance money until those bills are due. By keeping this money in escrow and paying these bills on your behalf, lenders have the assurance that their investment is being protected and that taxes are being paid as needed.
This is nice because it helps prevent you from getting behind on property taxes or home insurance, which could put you at a greater risk of losing your home otherwise.
These amounts are wrapped into your total monthly mortgage payment, commonly referred to as your “PITI” payment. Short for: Principle + Interest + Taxes + Insurance.
Payments for taxes & insurance can fluctuate due to a change in tax valuation or insurance rates. If this happens, the lender can change the amount they require you to put into escrow each month — which of course could make your mortgage payment go up, or down. To help with your mortgage payment, be sure to check out 4 Mortgage Hacks To Save You Money.