How engagement works when buying a home
When buying a home, you will undoubtedly come across the term “escrow” a few times.
And, if you are a first-time buyer, it can be confusing as different types of escrow are required when buying the home.
So, we are going to take a look at the main types of escrow you will face when buying a property.
Escrow is when a third party holds a particular asset until certain conditions are met. This service protects buyers and sellers, ensuring that both parties to the agreement fulfill their obligations.
Here is how it works.
As a buyer, you will be required to pay a deposit which will be deposited into an escrow account. An escrow agent will oversee this account, freeing up the funds to pay for the house if all goes as planned.
However, if the seller breaks the terms of the contract, the funds can be returned to the buyer. Alternatively, if a buyer decides not to make the purchase and the terms of the contract allow, their deposit can be returned to them.
Alternatively, if a buyer decides to opt out of the deal in a way that is not allowed in the contract, then the escrow funds can go to the seller to compensate them for their time and problems.
Therefore, holding the buyer’s funds in escrow encourages them to continue with the transaction as their money is in danger.
Escrow before buying
When a seller accepts the offer made by a buyer, a purchase contract is signed. Most likely, the buyer will then need to make a down payment fairly quickly, which will be deposited into an escrow account until closing.
Often times, a securities firm or real estate agent can act as the escrow agent responsible for managing the funds, as agreed in the contract. This involves disbursing the funds at the right time to the right person, as detailed in the terms of the purchase contract.
The deposit can represent 1% or 2% of the purchase price and shows that the buyer is serious and determined to buy the property. It can also be used for the down payment or to cover other closing costs.
During this time, the purchase contract is likely to contain contingencies that allow buyers and sellers to exit the agreement under certain conditions.
For example, if serious defects are found in the property during the home inspection, an inspection contingency could allow a buyer to walk away with a refund of their deposit. Conversely, if the buyer fails in his mortgage application, a contingency may allow the seller to find a new qualified buyer.
However, if a buyer decides they want to break the contract for reasons not covered by the unforeseen, they risk losing their deposit. But, if a contingency protects the buyer, he should get most of his deposit back.
Either way, escrow is an integral part of closing a property in most real estate transactions.
Escrow and lenders
Another important type of escrow involves your lender, although mortgage escrow does not work the same as seller escrow – it really only exists to protect the mortgage lender.
For example, when a mortgage lender lends money to a borrower, the house is guaranteed. If the borrower defaults on the loan, the house can be foreclosed, allowing the lender to get their money back. But, if the homeowner doesn’t pay their property taxes, it can potentially affect the lender.
Another potential problem is fire or some other type of property damage which, if uninsured, can affect the lender’s investment. For these reasons, mortgage lenders require an escrow to pay for home insurance and property taxes.
Normally, property taxes and insurance premiums must be paid annually, but mortgage escrow allows the borrower to pay these fees gradually each month.
The lender sets the required amount based on the previous year’s property taxes for the home, which also makes budgeting easier for the homeowner.
So instead of having to find a potentially substantial sum of money once a year to cover these taxes and premiums, the borrower does not have to worry about saving to cover those bills.
Finally, there may also be an additional expense on top of the additional monthly payments if taxes and insurance premiums go up.
But that should be less of a concern since most of the costs will have already been covered as part of the mortgage payments. A borrower can even get a repayment if they put too much money in escrow or if the loan is repaid.
What happens with the commitment at close?
Typically, if everything went as planned, the funds in escrow will be used for a down payment and other expenses at closing.
However, in certain situations, all or part of the deposit could be returned to the buyer. This can happen if the buyer does not need to make a down payment, such as through a VA or USDA loan. Or, sometimes the seller may agree to cover part of the closing costs, in which case the buyer will get back part of their down payment.
If a buyer is required to pay a mortgage escrow, they will need to make the upfront payments at closing, which could take at least two months of insurance and taxes to create a reserve.
Note that funds placed on deposit must be segregated from other funds. In fact, by law, the blocked money must be placed in a separate account by the agent.
A separate account is also important with mortgage escrow, because it makes it easier to separate mortgage and interest payments from the money you pay for taxes and insurance. And, while there is no legal requirement to place a deposit in an escrow account, it is a generally accepted standard.
As far as the escrow agent goes, it’s usually up to the buyer. The buyer’s real estate agent will likely be able to recommend a reputable agent, and the deposit should never go directly to the seller.
While mortgage escrow is not always required by lenders, loan terms could be better when required. For example, if you have a 20% down payment, you might be able to avoid mortgage escrow, but the lender might charge other fees.
As you can see, escrow funds can serve many purposes in a real estate transaction. Whether you are buying or selling a home, having at least a basic understanding of how escrow works is essential.
Disclosure: The information you read here is always objective. However, we sometimes receive compensation for clicking on links in our stories.