What is Escrow?

Referee
An escrow service can act as a referee for your purchase or sale. Jupiterimages/Photolibrary/Getty Images

You’re facing an important transaction, wondering if you can trust the person on the other side. That’s a common situation, and understanding the concept of escrow can help you minimize your risk and move forward more comfortably. Whether you’re dealing with a real estate transaction or an online sale, it’s worth learning what escrow means and how it works.

What is Escrow?

Escrow means that you’re using a “third party” (somebody who is neither the buyer or seller) to hold something of value, which helps to make your transaction safer.

Ideally, this would be a disinterested (or neutral) third party – who doesn’t care whether the buyer or seller comes out ahead. The job of an escrow service is simply to ensure that everybody sticks to their end of the bargain.

When you sign an agreement to buy or sell something, you agree to do certain things: the buyer will pay the agreed upon amount by a certain time, and the seller will provide the asset being sold. Of course, most transactions are more complicated than that. They buyer might want the right to inspect the property or goods she is buying, and the seller might want some assurance that she’ll actually get paid (or have the opportunity to move on if the deal is not happening quickly enough).

Who is the “referee” when you sign a complicated agreement? An escrow company can provide that service – ensuring that everybody does what they agreed to do, and acting as a middleman to safeguard assets in the process.

That’s why it’s important to use a trusted third party – a big-name escrow provider, or a service provider recommended by your real estate agent (assuming you trust your agent).

Real Estate Escrow

A common use of escrow is the sale and purchase of a home. Escrow opens when a signed agreement is delivered to an escrow officer, who helps to ensure that the conditions of the contract are all satisfied (that inspections, disclosures, and objections are completed or resolved on time, for example).

Escrow closes when everything is done and the property ownership is transferred to the buyer.

Perhaps the first time you’ll notice escrow in a home sale is when earnest money is paid. The buyer writes a check payable to the escrow holder, who will either refund the money, apply it to the purchase price, or pass forfeited funds on to the seller (if the buyer fails to meet any requirements). If the check was instead payable directly to the seller, the buyer would take a significant risk – what’s to stop a dishonest “seller” from cashing the check immediately and making it difficult for the buyer to complete the purchase?

Online Escrow

Escrow services can be used for more than home purchases. There are plenty of situations when a buyer and seller might benefit from a third party to watch over a transaction. Online sales are particularly risky – you’re dealing with somebody you don’t know anything about, and they might be many miles away (so taking legal action against a swindler would simply cost too much to be worth it).

Still, it’s nice to have a huge pool of potential buyers if you want to sell something. How can you make online transactions safe? It’s not always practical to demand that buyers send a “safe” form of payment up front – especially for expensive items – and sellers are routinely scammed online.

Trading in marketplaces where buyers and sellers have a “reputation” can improve your chances. If you’re a buyer, you can also try to make use of your credit card’s consumer protection features.

Another approach (which protects both buyers and sellers) is to have an escrow service handle the transaction. For example, a buyer and seller might agree on several terms:

  • How much the buyer must pay
  • How and when the seller will ship the goods
  • If (and for how long) the buyer is allowed to inspect and reject the goods

After submitting those details to an escrow service, the buyer and seller simply need to do what they agreed to do.

If the seller never ships, the buyer gets her money back. If the buyer says the goods never arrived (which some people claim in order to get things for free), the seller and escrow company will have shipping confirmations – and the buyer agreed to complete the transaction based on those confirmations.

Escrow Accounts

An escrow account is slightly different, but the idea is not far off. When you make your “monthly housing payments,” you might pay for more than just your home loan. Expenses such as homeowner’s insurance and property taxes might be baked into the payment as well.

Insurance premiums and property taxes are often annual expenses (although insurance companies will certainly accept monthly payments), and lenders aren’t always confident that homeowners will budget for those expenses properly. If you don’t make those payments, the lender is at risk, so ensuring that those expenses get paid is often part of your loan paperwork.

If you don’t have homeowner’s insurance, your house could burn down, leaving it worth less than you owe. If you don’t pay your taxes, the taxing authority could put a lien on your home and collect taxes due at a sale or foreclosure (and your lender would only be able to collect what’s left after the taxes are paid).

With an escrow account, the monthly portion of those expenses is added to your monthly payment and deposited into a separate account. Each year, when your insurance or tax bills are due, the money in that account is used to pay the bills (your lender handles this for you). So once again, the escrow account is money held by a third party (not you or your insurance company) to make sure that obligations are met.