When it comes to purchasing property, whether a parcel of land, a house, or even a boat, there are several steps that must be taken and terms that need to be met before the asset legally becomes yours. Escrow is an essential and often misunderstood part of the process. Read on to learn what escrow is, what it entails, and how it factors into the close of a sale.

What is escrow?

Escrow means to hold something in trust. It’s a legally binding agreement in which a third party holds money on behalf of two parties who are attempting to complete a financial transaction. The money stays in escrow with the neutral third party until each of the other two parties has met their contractual obligations. Only then is the money cleared to transfer to the receiving party.

Why is escrow important in real estate transactions?

The first step to buying a home is for the buyer to make an offer to the seller. If both parties can reach an agreement on price, the buyer makes a good faith deposit (also known as earnest money) into an escrow account. This is typically 1-to-2% of the purchase price.

Escrow gives the seller peace of mind in case the buyer doesn’t follow through with the purchase. It also protects the buyer in case there’s an issue.

For example, an offer is made, accepted, terms are drawn up, and a 1% deposit is placed in an escrow account. An inspector discovers structural issues that were not accounted for in the contract. If the seller refuses to cover the cost to fix the issues, the buyer can generally back out of the deal legally and get their deposit money back. They don’t have to worry about the seller refusing to return the earnest money since it was held in the third-party escrow account.

If the sale does move to the next stage, both parties sign all the required documentation and close the deal.  The deposit will be released at the title closing. 

If an escrow account is being used during the building of a new home, the money generally stays in escrow until the homeowner signs off on all the work. Once the agreed-upon conditions are met, the money will be released to the right party. 

READ: Everything You Need to Know About Construction Loans

How long does escrow take?

The escrow process takes 30-90 days, typically. The exact length of escrow depends on several factors, including who the escrow provider is, mortgage pre-approval, state requirements, completing the underwriting, and any repairs that are agreed upon and need to be made.

What happens if a sale doesn’t go through?

As stated earlier, there are certain scenarios where a sale doesn’t go through. If it happens due to issues that come up during inspection or if the seller decides to back out, the buyer will likely have their deposit returned.

If the buyer decides to back out of the sale due to financing problems, appraisal issues, or another reason not explicitly addressed in the contract, the deposit may not be returned depending on state laws and the terms of the original agreement.

When else is an escrow account used?

If money is borrowed from a mortgage lender or bank, the lender will typically open an escrow account into which the borrower/homeowner makes monthly deposits that cover property taxes and insurance premiums. When those bills are due, the money in the escrow account is used to pay them. Why? It’s a safety measure for the lender. Because the money in an escrow account is automatically deposited and flagged for these expenses, there is a reduced risk of the borrower/homeowner failing to pay their insurer or the government.

Most of these escrow accounts require a minimum balance of two months’ worth of expenses in case there are increases in cost. (If it’s a riskier mortgage, the minimum balance might need to be higher.) Every year, the lender reviews the account to ensure expenses are adequately covered and that the borrower/homeowner isn’t overpaying. 

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