Mortgage Escrow Explained

Mortgage escrow is a period during which the final contract of sale is being finalized on a home. During this time, the buyer has not yet made payments to the seller, but the seller needs to know the money will be available when it is required. As a result, a third party is used to hold the money in an account. The buyer places funds into this account, and bills for the sale, tax payment, closing costs and other expenses for the home are paid out of the account.

What Is Escrow?

Escrow is a term for the account, but it is often used to describe the period before closing on the purchase of a home. When a home buyer says he or she is "in escrow," it means the contract has been signed and the home has been officially purchased. However, while items like an inspection and property transfer are carried out, the home buyer places money in this third-party account instead of paying the seller directly. That way, if the contract does not go through for any reason, the money has not been transferred.

How Does an Escrow Account Work?

An escrow account has two important functions: first, to finalize the sale of the home and, second, to handle issues like property tax and insurance. The second function is actually the reason escrow accounts were created. Many home buyers were purchasing property without consideration of the expense of taxes and insurance, which resulted in foreclosures. Thus, mortgage companies began requiring forced savings accounts for these sums managed by a third party. Each month, a buyer pays a small amount to the account, and the taxes are paid from the account. Today, the accounts are also used for what has become the primary purpose: processing the sale.

Why Is an Escrow Account Required?

Escrow accounts are not required 100 percent of the time a home is sold. Actually, it is up to the mortgage lender, seller and buyer to determine the terms of escrow. Most mortgage lenders will require the account for the tax and insurance reasons mentioned. Sellers and buyers benefit from using the account during the sale process. Many buyers are tentative to simply cut a check to the seller for the price of the home until they are confident the sale will happen. Using an escrow account, the buyer can be assured the money will be held safe if the sale should fail to finalize.

What Is the Downside of Escrow?

While most buyers will want an escrow account, there are some downsides to maintaining the account. First, the third-party service used, typically an attorney, will charge a fee. If the escrow account is maintained to pay taxes and insurance, this fee will continue, despite the fact that the account does not earn interest. A savings account with moderate interest would be a better option. If a mortgage company requires an escrow account for these purposes, the buyer should consider limiting the length of time the account must be held to five years or shorter in order to reduce this expense.