How Escrow Relates to Your Real Estate Transaction
You'll probably hear the word "escrow" many times during your home buying transaction. The term can be confusing because it is used to describe different events that take place before and after the real estate settlement.
Let's look specifically at how real estate escrow works during the entire process of buying your home, from offer to close.
Escrow During the Home Buying Process
Broadly speaking, escrow includes documents—or something else of value, often money—held by a neutral third party in order to be used at a later date to fulfill an obligation. There are several ways this applies during the home-buying process.
Earnest Money Deposits
If you are buying a home, your first exposure to escrow will probably be associated with the earnest money deposit that accompanies your offer to purchase the house. That money will typically go into someone's trust account, where it will remain in escrow, protected by that neutral third party until it is credited to you when the transaction closes (or is dispersed in other ways if the transaction fails to close).
Be sure you have an inspection contingency in your contract so you can get your earnest money back if negotiations break down over issues related to the home inspection.
You'll hear the term escrow used to describe the title company, attorney, or another person who is hired to handle your closing transaction. That person is often called an escrow agent because they maintain all documents and funds related to the transaction until the day of closing.
Lender Escrow Accounts
The term escrow is used again to describe the escrow accounts your lender sets up in order to pay your home insurance and property taxes when they become due. You may remember the principal, interest, taxes, and insurance (PITI) when the lender calculated your projected monthly payment. Those four elements represent the components of each payment you will make each month.
Tax and insurance bills are typically sent directly to your lender. Both of those bills are paid annually, but most lenders require you to pay 1/12th of the annual bill each month. The lender deposits the partial payments in an escrow account, where they'll accumulate until it's time to pay your taxes and insurance the following year.
You will begin funding your escrow account and building up its value at closing when you're required to make an initial payment into the account.
The escrow portion of your monthly payment can increase (and sometimes decrease) each year based on changes in property value, tax rates, and homeowners insurance costs. Your lender will send you an annual escrow statement detailing these changes and reconciling your annual payment with your tax and insurance bills.
RESPA Guidelines for Escrow Accounts
The Real Estate Settlement Procedures Act (RESPA) includes laws that all lenders must follow when funding and managing your escrow accounts.
Although RESPA does not require borrowers to maintain an escrow account with their lender, most lenders will require it to ensure you're paying your taxes and keeping the property insured. The laws do regulate the maximum amounts that a lender can require a borrower to maintain in an escrow account.
Escrow Account Cushions
Lenders can require borrowers to keep a cushion, or excess balance, in their escrow accounts to cover unanticipated increases in the following year's tax and insurance bills.
The cushion cannot be more than one-sixth of the total amount paid out of the account each year. That usually amounts to two months of escrow payments. Most lenders now require that borrowers fund their escrow accounts to the maximum amounts.
Frequently Asked Questions
- Must lenders pay interest on money held in escrow accounts? RESPA does not require real estate lenders to pay interest on escrow accounts, but some states do.
- What if my lender doesn't pay my taxes on time? The lender should pay your taxes on time if your mortgage payments were paid on time. The lender must pay any penalties assessed to you for late payment. If the lender refuses, you can file a formal complaint with RESPA.
- What should I do if my lender doesn't pay my hazard insurance and the policy is canceled? Lenders are required to make payments on your behalf as long as you keep up with your mortgage payments. Contact the lender immediately and fax a copy of the insurance bill, making sure it is sent to the correct department. Talk to an attorney if you incur damages due to the lender's failure to pay. Some people opt to pay the past-due premium to make sure their coverage isn't terminated, then deal with the lender to get it back.
- What if my lender requires me to keep too much money in my real estate escrow? Ask your lender for an explanation if it requires that you keep an escrow cushion that equals more than the one-sixth excess funds mentioned above. If their response to you isn't satisfactory, file a complaint with HUD.