Buyers and sellers often have to work together based on trust—but that's scary. Fortunately, escrow services can make it less risky to do business. Escrow may be one of those financial terms you don’t hear every day, but the concept doesn’t need to be intimidating. Escrow accounts serve several basic needs, and we’ll cover each of them here.
What Is an Escrow Account?
An escrow account is an account designed to hold funds temporarily in safekeeping. The escrow provider should be a disinterested third party with no preference about who ultimately receives funds from the account. For example, in a real estate transaction, the escrow account does not favor the buyer or seller—they just follow the rules that buyers and sellers agree to.
Escrow accounts are useful in several situations:
- Homebuying: An earnest money deposit should stay in an escrow account to protect both the buyer and seller.
- Monthly payments: A homeowner might make deposits in an escrow account with each monthly payment, helping to smooth out large annual expenses.
- Renters and landlords: Escrow accounts can help protect the interests of renters and settle disputes.
- Buying goods and services: Escrow is an option for almost any transaction where buyers and sellers want a “referee” to oversee payment.
- Private capital market transactions: Escrow account arrangements are also common in certain private placements or mergers and acquisitions where companies acquire full or partial equity stakes in other companies. Prior to the deal closing and payment made, an escrow account is created where the money resides until all terms and conditions set in the arrangements are fulfilled by both parties to the deal.
We’ll cover each of these in more detail, but the common theme is using an account to hold money for safekeeping.
If you're using an escrow service for an online transaction, double-check to make sure the company is legitimate. The Better Business Bureau is a good starting point.
Buying or Selling a Home
Most people get their first exposure to escrow when buying or selling property. When making an offer, you often include an earnest money deposit to show the seller that you’re serious about buying. But you don’t want to just give money directly to the seller—you’d have to trust that the seller is financially secure, honest, and organized enough to return the deposit if things don't work out.
Buyers typically make earnest money checks payable to an escrow or title company. Doing so allows the seller to receive funds if you back out unexpectedly. At the same time, you can be confident that you’ll get your money back if there’s a problem with one of your contingencies (for example, you find something unacceptable at inspection).
The escrow provider should not care whether the buyer or seller gets the funds (although they might prefer to see the deal go through). They simply follow the terms of your purchase offer. Eventually, the escrow service either returns funds to the buyer or sends funds to the seller, depending on who is entitled to the money.
When you borrow money to buy a home, you may have to use an escrow account for monthly payments. Expenses like homeowners insurance and property taxes are often annual expenses, but most people think in terms of monthly payments—and large annual bills catch them by surprise.
To break those payments down into manageable pieces, lenders often require that you save a portion of the annual amount each month. With each monthly payment, your funds go toward your loan balance (principal and interest) as well as your taxes and insurance. Those payments are often called PITI payments. With each monthly payment, the amount for your taxes and insurance goes into an escrow account until annual bills come due. Here are a few considerations for escrow:
Is It Required or Optional?
Some lenders require that you use an escrow account. Even when they don’t, you might decide to voluntarily use one to make large annual expenses less burdensome. By spreading out the payments, you don’t have to scramble for funds when a semi-annual or annual bill comes in. Lenders often like to use escrow accounts because failing to pay taxes and insurance bills puts them at risk. If your house burns down, they want to get their money back, and taxing authorities may put a lien on your home, making it hard for you and the lender to sell.
Should You Do It Yourself?
If you don’t have an escrow account to smooth out payments, plan ahead. Expect to pay property taxes once or twice per year, and decide how to pay for homeowners insurance. You may be able to pay monthly (on your own), or you might just choose to pay the full annual amount in a lump sum.
In some cases, you can save money by paying expenses in a lump sum as soon as they're due. Ask your insurance company and local taxing authority what options are available.
Is It the Best Use of Your Money?
You might worry that you can earn more on your savings if you keep your funds in a high-yield savings account. That may be true, but evaluate the numbers with a critical eye. How much do you keep in your escrow account at any given time? Especially when interest rates are low, any extra earnings you might get at the bank of your choice won’t amount to much. Is it enough to move the needle on your finances?
Escrow Accounts for Renters
When it comes to renters, escrow may be useful in two ways. But check with a local real estate attorney and state regulators to confirm how things work in your area.
In some states, landlords must keep security deposits in an interest-bearing escrow account. That safety measure ensures that renters get their money back and that funds are available to make repairs if needed. If landlords just deposit funds in an operating account, it’s easy to lose track of the money and spend it on other needs.
When landlords fail to address renter needs (like the need for running water or heat), renters might be allowed to withhold rent payments. But in some states, renters are required to deposit the regular rent payment into an escrow account. Doing so protects the landlord and shows that the renters aren't just trying to avoid paying; they just want the services they’re paying for.
Your contingencies can help to facilitate almost any kind of transaction. By involving a third party to hold funds for safekeeping, buyers and sellers can feel confident about doing business. For example, when buying or selling online, you don’t know the person or company on the other end of the deal. If you’re concerned about getting ripped off, several online services can perform escrow duties for you.
Frequently Asked Questions (FAQs)
How do you open an escrow account?
For home buyers and sellers, a real estate agent will typically open an escrow account on your behalf. However, if you need to open one, you simply need to contact a bank and ask to open an escrow account. Be prepared to offer details about yourself, why you're opening the escrow, and information about any other parties involved in the escrow.
Who gets the interest earned on money held in escrow?
State law may determine who gets the interest earned on money in escrow. In California, for instance, homeowners who make mortgage or property tax payments through an escrow account are entitled to the interest earned on that money. Not all states have these types of rules, and it may depend on the bank involved.