What is Escrow?
The basic definition of escrow is to give something of value, such as money or a deed, to a third party who will hold the valuable until certain requirements have been met. Typically in real estate, escrow is held in an account in the borrower's name. There are two main purposes for escrow in real estate.
Escrow Uses in Real Estate
Escrow is most commonly used for collecting annual property tax and home insurance payments. Your lender will roll the monthly tax and insurance expenses into your mortgage payments, however the money is kept in a separate escrow account. When your taxes and home insurance are due the lender draws the correct amount from the escrow account and pays them for you. Any remaining money can either be kept in the account or dispersed to you.
Less commonly escrow refers to closing in escrow. This is when a designated third party, rather than a settlement company, holds deed and money being transferred in the real estate transaction and manages the transfer of the assets. This method is sometimes used when the buyers and sellers won't be present at the same time for closing.
However escrow laws and regulations vary from state to state so consult a lawyer or real estate agent about your area for specifics. Be aware that escrow is also regulated by the Real Estate Settlement Procedures Act (RESPA).
Pros and Cons of an Escrow Account
Again the laws vary, but in most cases lenders can choose to require escrow account deposits if the loan is for more than 80% of the property value. For those with the option it's best to make this decision well in advance because it will affect the closing costs and HUD-1 settlement statement. Below are some things to keep in mind when you discuss escrow with your lender.
The Benefits of an Escrow Account
The obvious benefit of having an escrow account is that it eliminates the risk of not making your property tax and home insurance payments. Some people literally forget to pay and some people underestimate how much the costs will be and are short when the payments are due. Regardless, it's good to know that they're being handled and are basically on auto-pilot with an escrow account.
Also, some lenders use escrow funds to make investments and will share the profits that they make with you.
The Drawbacks of an Escrow Account
The obvious one here is that you'll have lower monthly mortgage payments, however, actual savings are lost whenever the tax and insurance payments are due. The real monetary concern is the up-front costs of establishing the escrow account. You may be charged a one-time set up fee for the escrow account which typically costs $60-75 and you'll also be require you deposit a specific amount into the escrow account right off the bat.
There also the concern that the responsible party may not make your tax and insurance payments on time or for the correct amount. To avoid this potential problem carefully examine your escrow statements.
Your lender is required to send you a statement detailing your escrow account activity at least once a year. Make sure to verify that they are calculating your tax and insurance expenses correctly and verify that the due dates for payment are correct. Borrowers also have the right to demand that their lenders provide you with proof of payment.
Final Thoughts on Escrow
Though some feel that escrow accounts are more beneficial to lenders, borrowers nonetheless find great use for them. You have to pay your taxes and insurance anyway, so why not make it easy on yourself and have it taken care of in escrow?
Just be diligent about keeping track of your escrow account activity and don't rely on your lenders to get everything right all the time.