An escrow is a financial agreement in which a third party controls payments between two transacting parties and only releases the funds involved when all of the terms of a given contract are met.
Understanding the concept of escrow can help you minimize your risk when large amounts of money are trading hands, 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.
Definition and Example of Escrow
Escrow is a financial arrangement in which two parties enlist a third party (who is neither the buyer nor the seller) to temporarily hold money, paperwork, or other assets for a transaction on their behalf before the transaction has been finalized.
That third party, known as an escrow provider, helps make the transaction safer by protecting the assets of the buyer and seller until both parties have met their obligations for the agreement.
Ideally, the escrow agent or provider is a neutral third party who isn't concerned with whether the buyer or seller comes out ahead.
For instance, if you hire a contractor to remodel your kitchen for a large sum of money, you can place the funds to be paid with a third party agent at a bank, and form a contract to release the money to the contractor once the work is completed, with a clause that defines satisfactory completion. This serves everyone involved, because the contractor has assurances that they will be paid, and you have assurances that the work will be completed to your satisfaction.
How Escrow Works
When you commit to buying or selling something, you agree to fulfill certain terms. For example, the buyer must pay the agreed-upon amount by a specific time, and the seller must provide the asset being sold. Of course, most transactions are more complicated than that. For example:
- Buyers might want the right to inspect the property or goods they are buying before paying.
- Sellers might want some assurance that they'll get paid (or have the opportunity to move on if the deal isn't happening quickly enough).
- The item being sold might be a service instead of a product.
In complicated arrangements like these, one party may feel unsure that the other will meet their end of the bargain, creating the need for a third party to act as a "referee." The escrow provider acts as this middleman and ensures that the buyer and seller do what they agreed to do.
The escrow provider's responsibilities in a transaction include receiving assets from one party, disbursing funds according to the terms of the escrow agreement, and closing escrow. Their role in the transaction safeguards the assets of buyers and sellers before they get transferred from one party to the other.
Of course, given the ample assets at stake in big transactions, you should use a trusted escrow provider—a big-name escrow company or a service provider recommended by your real estate agent.
When looking for escrow providers, do your due diligence and search for the company online with the word "complaint" to dredge up any negative reports. Likewise, check to see if the provider must be licensed in the state in which it operates—and then confirm that it is licensed.
Types of Escrow
Escrow can be used in any number of financial and legal scenarios where something of value exchanges hands from one party to another. But it frequently applies to real estate and online transactions.
Real Estate Escrow
Escrow is commonly used when you buy or sell a home. Escrow opens when a signed agreement is delivered to an escrow officer, who ensures that the conditions of the contract are all satisfied. For example, the officer might verify that home inspections, disclosures, and objections are completed or resolved on time. Escrow closes when the purchase money is disbursed to the seller and the title is recorded in the name of 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 the requirements of the contract. Escrow closes when the purchase money is disbursed to the seller and the title is recorded in the name of the buyer.
If the check was payable directly to the seller instead, the buyer would take a significant risk. In that case, there would be little to stop a dishonest “seller” from cashing the check immediately and making it difficult for the buyer to complete the purchase.
An escrow account is an account where assets are held by a third party (not you or your insurance company) to make sure that you meet your obligations. Escrow accounts are commonly used for monthly payments on a home.
When you make your monthly housing payments, you probably pay for more than just your home loan. Expenses such as homeowner’s insurance premiums and property taxes are often baked into the payment. These are often annual expenses (although insurance companies may 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.
After all, if you don’t have homeowner’s insurance, your house could burn down, leaving it worth less than you owe. Likewise, 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.
That's why ensuring that these expenses get paid is often part of your loan paperwork. Lenders often require escrow accounts to help make sure these expenses get paid on time. Your lender sets up the escrow account, adds the monthly portion of those expenses to your monthly payment, and then deposits the money into a separate escrow account. Each year, when your insurance or tax bills are due, your lender pays those bills for you from that account.
If your lender doesn't set up an escrow account for you, you will need to budget for these monthly expenses on your own. For this reason, it will benefit you to request an escrow account even if your lender doesn't require one.
Escrow services are useful for more than just home purchases. 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).
As a buyer dealing with a dishonest seller, you may not get the goods you purchased. In addition, online scammers routinely take advantage of sellers. But it’s not always practical to demand that buyers send a safe form of payment upfront—especially for expensive items.
There are a few ways to make online transactions safe:
- Trading in marketplaces where buyers and sellers have a reputation can improve the odds of completing a safe, successful transaction.
- If you’re a buyer, make use of your credit card’s consumer protection features.
- A third approach (which protects both buyers and sellers) is to have an escrow service handle the transaction.
During an online sale, 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
If you enlist an escrow service for that sale, after providing those details to the 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 bad actors may claim in order 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 is a financial agreement in which a third party controls payments between two parties and only releases the funds involved once a contract's terms are met.
- This third party temporarily holds money, paperwork, or other assets for a transaction on their behalf.
- Ideally, the escrow provider is a neutral third party who isn't concerned with whether the buyer or seller comes out ahead.
- Escrow frequently applies to real estate and online transactions.