Understanding The Mortgage Escrow Process

If you’re preparing to buy a home, get ready to familiarize yourself with a new word: escrow. Escrow refers to a financial instrument, typically an account, which is maintained by a neutral third party on behalf of two other parties engaged in a financial transaction — like a home purchase. In order for a party to actually receive the money, certain conditions have to be met along the way, which will be outlined in the purchase contract.

Escrow may play a continuing role after closing day, too, depending on how much money you put down on the property. Read on to learn about how escrow accounts work when you’re a homebuyer — and when you become a homeowner.

How does escrow work when buying a house?

“Escrow” is short for escrow accounts. In real estate, there are three common types of escrow accounts.

Home purchase

When you first go to contract to purchase a home, you’ll likely need to put a chunk of money in a homebuyer’s escrow account. It’s a show of good faith that you actually intend to move forward with buying the property.

“The purchase agreement usually includes a provision for the buyer to provide an earnest money deposit,” explains Thomas Trott, Jr., co-founder of Maryland-based Victory Mortgage Solutions.

The earnest money deposit — generally 1 percent to 2 percent of the home’s purchase price — is held in an escrow account until the contract is finalized, after which the funds will go toward the buyer’s down payment or closing costs. If the agreement is voided, the deposit will go to either the buyer or seller, depending on what the contract stipulates.

Unresolved items in real estate contracts

Escrow may also involve anything unresolved in the real estate contract.

“For example, if the seller left furniture, did not complete repairs or if the property was damaged, the settlement company may hold back the seller’s funds in escrow until the contract is fulfilled,” says Trott. “Once fulfilled, the funds would go back to the seller or be used to pay for outstanding bills.”

There are other niche cases where sellers will leave money in escrow, too. For example, say a buyer is purchasing a property in a building or community with plans for a sizable special assessment — a new roof or new windows, for example — in the near future. The buyer may ask the seller to put money in escrow to cover that cost.

Steps in the escrow process

After you successfully bid on a home and sign a purchase and sale agreement with the seller, the escrow process is initiated, which includes several phases. Your earnest money will remain in the escrow account throughout this process until you reach the final step of the home purchase, which is the closing.

1. Opening an escrow account

The first step is to open an escrow account, which is usually done by the seller, but can also be done by the buyer.

“Once an offer is made and accepted, the contract will stipulate when the escrow deposit is due,” said Ralph DiBugnara, president of Home Qualified, a real estate resource and web series. “In most cases, the deposit is split into two parts — first an initial, good-faith deposit followed by the remainder of the deposit.”

The initial deposit is typically due within seven to 10 days of signing the contract. This earnest money will eventually be applied to your overall down payment on the home.

The agent holding the escrow account could be a title business specializing in real estate, a bank or other financial firm, or it could be a private third-party entrusted with the task. Alternatively, a real estate attorney can manage this process, in which case it might be referred to as “settlement” instead of “escrow.”

2. Appraisal and home inspection

Your mortgage lender will order an appraisal of the home. If the appraised value of the home is less than the proposed purchase price, your lender will not grant you the funds for your mortgage unless you’re willing to pay the difference in cash or the seller agrees to lower the price to the appraised value.

As the buyer, you have the option to hire a home inspector to carefully evaluate the home and its habitability. It’s an important step in the escrow process that allows homebuyers to get a deeper look at the condition of the property, including its structural integrity, electrical and plumbing systems, heating system and more.

“Most responsible real estate agents advise against waiving an inspection,” said Katie Severance, a real estate agent with Douglas Elliman in Palm Beach, Florida.

You’ll also want to review disclosures from the seller. The seller is obligated to report known negative conditions or flaws that presently exist with the home, such as the presence of lead paint or asbestos.

3. Obtaining insurance coverage

Your mortgage lender will require you to obtain homeowners insurance for the property, and to pay for title insurance. Unless you get an additional owner’s policy, title insurance primarily protects the lender from any legal challenges that could surface from defects with the home’s title or ownership.

4. Final walkthrough

Assuming all goes well with the appraisal and inspection — and nothing changes in your financial situation that could derail your mortgage approval — you’ll have an opportunity to visit the home just prior to closing for a final walkthrough. This helps ensure there’s no new damage to the home and that the seller has fulfilled the terms of the purchase contract, such as leaving behind appliances or fixtures they agreed on.

“The purpose of the walkthrough is to confirm that the home is in the same condition that it was on the day of the inspection,” said Severance. “Things to be done include walking the entire exterior of the property looking for any obvious issues.”

It’s also a good idea to check that the home’s water pressure is still good and that there haven’t been any plumbing problems, which can be checked by running all of the home’s water sources including sinks, faucets, tubs, showers, and the dishwasher, says Severance.

Unless a major issue is discovered, buyers are generally not allowed to back out of the purchase at this stage without forfeiting the earnest money in the homebuyer’s escrow account.

5. Closing

At least three business days prior to closing the transaction, you’ll receive a closing disclosure document from your lender with a finalized list of closing costs, including escrow amounts. Compare this to your loan estimate (which you received when you applied for the loan) to ensure there aren’t any material changes to the costs.

When it’s time to close, the escrow agent will create a document naming you as the homeowner and file it with the local records office, then wire the funds to your escrow account so the seller and seller’s lender can be paid. For the remaining down payment and closing costs, you’ll need a cashier’s check.

Escrow accounts for homeowners

After you buy your home, a different kind of escrow account is managed by your mortgage lender or servicer, with the funds in this account being used to pay your property taxes, homeowners insurance and (if you’re required to have it) mortgage insurance. Here’s a look at what it means for you:

• A monthly payment that includes more than principal and interest: When you were setting a budget for buying a home, you likely focused on the two biggest line items: the principal and interest. However, owning a home involves other expenses including property taxes and homeowners insurance. With an escrow account, your lender will divide these yearly costs by 12 and add them to your monthly mortgage payment.
• No need to worry about paying those additional bills: When your property taxes, homeowners insurance or mortgage insurance bills are due, the mortgage servicer or lender will pay the bills on your behalf automatically from your escrow account balance. That can provide some peace of mind since you don’t need to set a reminder to pay any of these bills on time.
• Regular updates to your monthly payment amount: If you have a fixed-rate mortgage, the amount you pay for principal and interest will always remain the same. Property taxes and homeowners insurance, on the other hand, can vary, and in most cases, they will regularly increase. You’ll know what to expect, though, thanks to an escrow account statement from your lender. This will typically show up in your mailbox near the end of the year, and it includes information about the costs of your insurance and property taxes. These statements inform you whether your escrow payments will increase, decrease or stay the same in the coming year.

Is escrow required?

In some cases, yes. Homebuyers are mandated by a mortgage lender to have an escrow account if the home purchase is being paid for with a government-backed loan, like an FHA loan or a USDA loan. The Veterans Administration (VA) does not require escrow accounts for a VA loan, but the mortgage lender used to actually finance these types of loans may require one. And with conventional loans, you’re likely going to need to have an escrow account if your down payment is less than 20 percent of the purchase price.

If you’ve chosen to have a mortgage escrow account for convenience, you usually can close it at any time. If the escrow account has been mandated by your lender, it gets more complicated. You might be able to terminate a mortgage escrow account eventually, although the restrictions for doing so vary from lender to lender. If you’re interested in trying to remove your escrow account, contact your lender to learn about the process and any fees involved.