The first stop on your Google search was probably Wikipedia’s very technical definition of escrow:
a. An arrangement made under contractual provisions between transacting parties, whereby an independent trusted third party receives and disburses money or documents for the transacting parties, with the timing of such disbursement by the third party dependent on the fulfillment of contractually agreed conditions by the transacting parties, or
b. An account established by a broker, under the provisions of license law, for the purpose of holding funds on behalf of the broker’s principal or some other person until the consummation or termination of a transaction; or,
c. A trust account held in the borrower’s name to pay obligations such as property taxes and insurance premiums.
Did you get all that? If your attention span started to wander at “whereby,” you aren’t alone.
So what does escrow mean to humans without law degrees? Escrow is a term used in many types of businesses, but to keep things simple, we’re going to limit this discussion to what escrow means in terms of real estate.
Escrow can be three things, and if we take those Wikipedia items in reverse order, they might make a little more sense.
A trust account to pay property tax and insurance
When a homeowner pays their mortgage each month, a portion of that check is put in an escrow account held by the bank to pay the property taxes and insurance. This is because, in the most technical sense, when you take out a mortgage you don’t own a home, you’re financing it through the bank.
This escrow account protects the bank. Because the bank has a security interest in your home, you are required to pay taxes and mortgage insurance to live in your home. Therefore, the bank knows those two very important bills are getting paid in full and on time. The homeowner also benefits because he or she gets to pay both the property tax and insurance premiums in smaller increments instead of getting hit with lump sums every six months to a year.
There are specific regulations about how large of a balance your lender has to maintain in that escrow account in case of a huge spike in taxes or premiums. Your bank will update you annually on the status of the escrow account and if any adjustment is needed.
An account established by a broker
Before you need to worry about taxes and insurance, you’re going to want to close the deal on a house. There are two important checks you might write along the way: earnest money (sometimes called a deposit) and a down payment, and chances are that you don’t want to hand checks that important over to a stranger.
In this case, an escrow account is a safe place to put your money and the funds you’ve borrowed until the deal closes. The bank will usually put the funds you’ve borrowed directly into the escrow account to save you the hassle of transferring funds in and out of your personal account. The escrow account is held by a neutral third party (often a title company), and which state you live in determines who (you or the seller) gets to choose that third party.
When you, the lender and the seller are all comfortable that the conditions of sale have been met, a new deed is recorded in your name. Then the funds in the escrow account are used to pay the commissions you have negotiated for any consultants (realtors, title company etc.) and the remainder is transferred to the seller.
Escrow is also the term used to describe the agreement to create either of the above types of accounts. That one was so easy, we saved it for last.
Remember, your mortgage banker deals with the ins and outs of escrow every day, so feel free to ask him or her to explain any details that are specific to your situation.