Large transactions demand a fair amount of safeguards. Who pays first, for example, between a seller letting go of an asset as valuable as a house, and a buyer parting with a large chunk of their savings? Who makes sure all obligations are fulfilled before the deal closes?
The market solution to this and other similar problems comes in the form of escrow. Although a common enough term within the real estate business, surprisingly, few ordinary people understand escrow and its importance.
In this article, we take a look at escrow, and examine the various processes involved, its importance in real estate and other businesses, and useful tips when handling it.
What is Escrow?
In the most general terms, escrow is a financial device used by two parties involved in a large and/or complex transaction. It involves said parties transferring the funds and assets to be exchanged to a trusted third party (the escrow company), for them to hold until all obligations which bind the transacting parties are met. Occasionally, the escrow agent even plays a role in facilitating the accomplishment of these obligations.
Many find it helpful to think of escrow using the metaphor of a wooden wheel: the escrow agent is the center of the wheel, which connects the various “spokes” or obligations held by either side of the transaction such as the buyer’s obligation to secure financing, and the seller’s obligation to permit various inspections of the asset.
Alternately, you could think of escrow as a safe, neutral space to hold the assets-for-trade in stasis while the rest of the deal is being ironed out. In this sense, it works much like a bank safe, only without interest, and accessible only after a particular set of conditions are met.
In the real estate market, the job of escrow is performed by firms which hold the cash and title while buyer and seller negotiate terms, perform their inspections and appraisals, secure funding, apply for insurance, and fulfill other necessary pre-closing tasks.
Finally, it’s important to note that an escrow service is notably different from an escrow account. The latter is a special arrangement with the bank that handles your mortgage, wherein the bank also collects monthly payments for your property tax and home insurance. This will be discussed at greater length at the end of the article, but for now it’s enough to note that the simple term of “escrow” can have many meanings.
Why the Need for Escrow?
As a device to facilitate trade, escrow is necessary to overcome the potential lack of trust between buyer and seller when highly valuable assets are being exchanged. The reputation and authority of an escrow agency makes it possible to hold both sides of a sale accountable for their commitments, prevents buyers from making dubious promises, and prevents sellers from running away with a pledged deposit.
Moreover, it allows for a clear time-frame to be set for both parties, ensuring that neither leaves the other at a particularly terrible disadvantage due to wasted time and lost business opportunities.
With state policy requiring escrow accounts for houses purchased through many various loan types, and generally for loans comprising 80% or more than the sale price, it’s good to know how escrow as a financial tool to facilitate tax and insurance (TI) payments can work in your favor. It offers homeowners greater control over their resources by dividing the yearly dues into neat, monthly installments which they have to set aside. While some might have perfect financial self-control over their budgets, this benefits many by making the practice of saving compulsory.
In short, escrow is a great solution to classic trade problems, and it keeps people safe from the kinds of nightmare scenarios that leave people cheated, penniless, or, worse, in deep trouble with the government for failing to deliver on important payments.
There are very few compelling reasons against it, so strongly consider keeping escrow a fixture in all your real estate ventures.
The Escrow Process in Real Estate
The usual routine that happens after signing a purchase agreement is as follows:
Instructions
To set things off, the escrow company produces a comprehensive set of instructions to both the buyer and the seller based on conventional and negotiated guidelines. These are critical as it essentially describes in detail the obligations of either party–and consequently, what kinds of actions and omissions can cost one or the other should the process fall apart.
Earnest Money
Then, the buyer begins the process proper by depositing their earnest money (essentially, a deposit made to signify a commitment to purchase an asset at a later date) in an account set up with an escrow company.
Home Appraisal
Afterwards, the financial institution responsible for loaning the buyer funds for the exchange (in most cases, a bank handling the mortgage) appraises the property for sale. This is to create peace of mind in the event of a foreclosure and can sometimes result in a property being valued at a lower price than the agreed sum.
In cases like these where the bank suspects that the buyer is being overcharged, said bank may refuse to finance the purchase until the difference is supplied by the seller. Otherwise, they may be convinced to re-evaluate their appraisal in the buyer’s favor.
Approved Loan Commitment
The buyer then supplies a final, approved loan commitment, indicating the principal amount, interest regime, closing costs, and other associated expenses. Following this, the financing contingency is removed and the buyer can no longer back out whilst retaining their full deposit.
Disclosures
The next step is a seller’s obligation, and requires the seller to provide a full set of disclosures as required by law. This includes problems and concerns surrounding the property which may or may not have been included on the original listing: issues such as housing code violations or–goodness forbid–crimes committed on-site.
Home Inspection
It’s typically after this that the seller opens the property up to inspection–and while the law doesn’t require buyers to conduct inspections, it’s definitely something they’re better off doing. Home inspections, as well as inspections for pests and other potential hazards and inconveniences can reveal crucial information about the actual state of the house, which ought to be ironed out while in escrow.
Homeowner’s Insurance
The buyer proceeds to securing homeowner’s insurance, and a title report to verify that nobody apart from the seller has ownership over the property in question. Another form of insurance comes into play after the title search, protecting the buyer from legal liability in the event of defects in the title claim found after the sale.
Final Property Walkthrough
The only remaining steps are the final walkthrough of the property to check for significant damage –which would be highly unlikely, making this step a formality more than anything– and reviewing the HUD-1 form or the final statement from the financial institution responsible for loaning to the buyer. As long as the house is in decent shape and your HUD-1 doesn’t heap excessive fees on top of the amount detailed in the estimate provided earlier in this process, you’re ready to close.
The Final Transfer
Closing escrow has a variety of nuances across states, but commonly involves the final transfer of funds (i.e. your down payment, loan funds, and closing costs) after signing a mountain of paperwork. From this point on, the house transfers to the buyer, and the seller gets to take home the proceeds of their sale.
Making the Most Out of Your Time in Escrow
The escrow process, though long and complex, is far from complicated, and a reliable agent can get you through its haziest parts. But that having been said, there are things that every potential buyer or seller should know before diving into escrow.
Time is of the essence
For buyers, it’s important to note that the timely delivery of your loan documents is ultimately your obligation, meaning you can stand to lose your deposit if your financiers are slow to deliver. This might not be optimal (or perhaps even fair), but it’s how the system works and remains to be a critical possibility to consider when choosing where to source your mortgage.
Get involved in appraisals and inspections
Another concern for buyers should be the importance of the home inspection period. It’s worth the cost of hiring specialists for everything from termites to wiring, as their findings could give you leverage in negotiating away expenses you’d have to make on repairs. Odds are your agent, bank, or escrow company would have at least one recommendation, so take advantage of the window of opportunity while it’s there. Finally, be around for the process since it’s typically much easier to follow inspectors’ findings on the fly than through written reports.
Sellers should be equally invested in making the escrow process as seamless and thorough as possible. Should any discrepancies or skeletons (hopefully of the figurative sort) turn up that weren’t included in your disclosures, you’ll find your peace of mind-melting away as quickly as your reputation. Remember, when you’re dealing with the housing market post-financial crisis, the only way to win is through fair play.
Both parties should make the most out of the period of time before contingencies are dropped to review (alongside their agents and/or legal counsel) the terms, finding, and data compiled by the escrow company up to that point in the process. It conventionally lasts for 17 days and marks the turning point before the deal is as good as set in stone and contingencies are all but gone.
Assorted Terms Related to Escrow
By this point, most of what can be said of the escrow process has been exhausted. Yet a handful of terms remain that could prove useful in understanding the concept to its fullest.
An escrow agent, simply put, is the representative of the escrow company responsible for handling a given transaction.
An escrow agreement refers to the set of instructions drafted and signed at the beginning of the escrow process. It’s a legal document with binding stipulations, so it’s frequently used by a party to ensure the capacity and commitment of another to conduct a significant transaction.
Outside the realm of real estate, bulk sales escrow agreements are placed on transactions involving a significant share or even entirety of a business’ assets. For businesses with outstanding debts, it’s a means by which their creditors can be guaranteed payment after downsizing or liquidation: an escrow company holds the proceeds of the sale and transfers them to creditors, rather than leaving the responsibility to a business which may funnel the earnings into new ventures.
Finally, when a bond is escrowed to maturity, it means that the funds used to make coupon payments and installments on the principal amount are held in an escrow account similar, similar to how taxes and insurance payments are held by banks on behalf of homeowners paying off their mortgages. These funds are typically held in the form of short-term securities to ward against losses to inflation.
Escrow Accounts: Shortage and Surplus
The last point this article seeks to make concerns the payment of taxes and insurance through escrow accounts. While it may have seemed perfectly clear-cut in the earlier description, escrow accounts have unpredictable elements to it that can catch new homeowners off-guard.
It’s common enough knowledge that your mortgage payments break down into four essential components, namely the principal amount and interest on a housing loan, property tax, and insurance payments. The former two (principal and interest, or PI) must be paid off in monthly installments to the bank. The latter two comprise one’s escrow account.
Escrow accounts work by taking an estimate of tax and insurance rates for the following year, and collecting money over a twelve-month period in anticipation of those payments. But since these rates fluctuate fairly rapidly, it’s possible that the projected amount that an account was saving up towards won’t perfectly match the real amount set by the government and market forces.
In the event of shortage, or real TI dues turning out larger than expected, homeowners have one of two options available: either make up for the difference lump sum payments before it’s time to collect, or allow the bank to advance the deficit (as they’re required to do by law) and pay off the difference across the next year on top of its own expected TI payments.
In the rare event of surplus, or TI payments turning out cheaper than expected, the bank is required to remit your excess deposits.
