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What Is Escrow and How Does It Work?

what is escrow and how does it work

Escrow is a legal term that describes a trust arrangement between two parties. It is the act of depositing something of value, usually cash or documents, with a neutral third party who only delivers the deposited items when certain conditions are met.

How does escrow work?

If you’re in escrow for a home purchase, an escrow agent (usually the title company conducting the closing) will gather and hold the seller’s deed, your down payment and the mortgage money your receive from the bank. They will then perform various tasks required by the sale and purchase agreement, such as obtaining approval to the home inspection report and taking out a title insurance policy.

When the contract contingencies are met, the escrow agent will pay the closing money to the seller and record the deed and loan documents in the appropriate county office, thus transferring the property to the buyer. At this point, escrow is said to be closed.

What about escrow for mortgages?

Here’s the confusing part: there’s more than one kind of escrow, and more than one time you may run into it when buying a house.

Mortgage lenders require that you not only make your mortgage repayment, but also that you insure your home and pay your property taxes on time. These payments commonly go by the acronym “PITI”:

To safeguard their investment, many lenders collect your PITI payments prorated by month, together with a two-month cushion to guard against tax increases. The money is deposited in escrow and used to pay your bills when they arise.

Here’s how it works: Say your lender determines that you’ll need $6,000 every year to pay your property taxes and homeowners insurance bill. To make sure you have enough to cover this cost, your lender will require you to pay an extra $500 each month—12 months multiplied by $500 a month equals the $6,000 you need—with your mortgage payments. When your property taxes and insurance payments are due, your lender will pay these on your behalf.

Your lender is also allowed to collect an extra two months of escrow payments each year to cover property tax or insurance bills that are unexpectedly higher than anticipated. At the end of the year, your lender is required to refund any amount over $50 in your escrow account.

Under the Real Estate Settlement Procedures Act, lenders must send you an annual statement showing the amount held in your escrow account and projected payments for the coming year. If your account shows deficiencies, your lender may raise your monthly payment. Excesses of $50 or more must be returned to you within 30 days of the annual statement.

What is a repair escrow?

A repair escrow is an account set aside at closing to pay for the repairs the property needs to reach its full appraised value.

Here’s how it works: in the case of a flooded basement, an appraiser will evaluate how much the repairs will increase the value of the property. The higher appraisal then allows the lender to increase your loan amount, provided you have demonstrated adequate income to cover the increase. That extra money from you lender goes into an escrow account set up at closing to pay for the needed repairs. When the work is completed, the funds are released and the escrow is closed.

Some other things to keep in mind:

When the work is finished, your new home has increased in value and your monthly mortgage payments have increased only a few dollars. Best of all, you have a dry basement.

Why bother with escrow?

Escrow takes the stress out of home ownership. During the home purchase process, escrow ensures that the property and its title are “clean” before the seller cashes any checks. After closing, mortgage escrow ensures that your bills are paid on time and your property is properly insured against hazards—providing invaluable peace of mind for home buyers.

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