What Is Escrow?
In a significant transaction, you may wonder if you can trust the person on the other side of the deal. That’s a common situation in a world where we frequently buy from people and businesses that we don’t know anything about. But 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 is an arrangement where you use a “third party” (somebody who is neither the buyer or seller) to hold something of value. That third party helps to make the transaction safer by ensuring that both the buyer and seller meet their obligations.
Ideally, the escrow provider is 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 agree to buy or sell something, you agree to do certain things: The buyer will pay the agreed upon amount by a specific time, and the seller will provide the asset being sold. Of course, most transactions are more complicated than that. For example:
- The buyer might want the right to inspect the property or goods she is buying before paying.
- 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).
- The item being sold might be a service instead of a product.
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.
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. For example, the escrow provider will verify that inspections, disclosures, and objections are completed or resolved on time.
Escrow closes when everything is done and the property ownership transfers to the buyer.
An earnest money deposit is probably the first time you’ll notice escrow in a home sale. 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 payable directly to the seller instead, the buyer would take a significant risk. In that case, there’s little to stop a dishonest “seller” from cashing the check immediately and making it difficult for the buyer to complete the purchase.
Escrow services are useful for more than just home purchases. Buyers and sellers frequently benefit from a third party watching 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 cost too much to be worth it).
It’s nice to have a huge pool of potential buyers if you want to sell something. So 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—but online scammers routinely take advantage of sellers.
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 the goods and reject them if dissatisfied with the quality
After providing those details to an escrow service, the buyer and seller just need to do what they agreed to do. If the seller never ships anything, the buyer gets her money back from the escrow provider. If the buyer says the goods never arrived (which some people claim to get things for free), the seller and escrow company can review shipping confirmations. If the buyer agreed to complete the transaction based on those confirmations and there’s proof of shipment, the escrow provider pays the seller.
An escrow account is slightly different from an escrow process, but the idea is similar. When you make your “monthly housing payments,” you probably pay for more than just your home loan. Expenses such as homeowner’s insurance and property taxes are often baked into the payment.
Insurance premiums and property taxes are often annual expenses (although insurance companies will certainly accept monthly payments), but lenders can’t always be 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. And if you don’t pay your taxes, the local taxing authority could put a lien on your home and collect taxes due at a sale or foreclosure. If that happens, your lender would only be able to collect what’s left after the taxes are paid.
With an escrow account, your lender adds the monthly portion of those expenses to your monthly payment and deposits the money into a separate account. Each year, when your insurance or tax bills are due, your lender pays those bills for you from that account. So, once again, the escrow account is money held by a third party (not you or your insurance company) to make sure that you meet your obligations.