What does escrow mean and how does it work?

When you start your homebuying search, you’ll probably hear the word “escrow” used a lot. An escrow account could provide important protections for both homebuyers and sellers. But what exactly is it? 

Understanding how escrow works can help you navigate the homebuying process. Read on to learn what escrow is and why it matters.  

Key takeaways

• An escrow agreement allows a third party to hold money or property until certain terms of an agreement—like purchasing a home—are complete.
• In real estate, there are two types of escrow accounts: a homebuyers escrow and a homeowners escrow.
• Homebuyers can use an escrow account to hold their earnest money and down payment until the home purchase is finalized. 
• Lenders may use an escrow account to manage the parts of a borrower’s mortgage payments that are related to homeownership costs, such as property taxes.

From down payments to homeowners insurance premiums, there are many expenses associated with buying, selling or financing a home. A financial tool known as an escrow account is typically used to manage these costs. 

Keeping funds in an escrow account can help protect buyers, sellers and lenders throughout the homebuying and mortgage lending process. That’s because an escrow agreement allows a neutral third party to hold money or property until the two other parties meet all terms of their agreement. 

There are two types of escrow accounts used for real estate transactions:

• Homebuyers escrow: An account used to hold earnest money on behalf of the homebuyer and seller.
• Homeowners escrow: An account used to hold a portion of monthly mortgage payments on behalf of the homeowner and lender. 

Once a homebuyer’s offer is accepted, their earnest money deposit—often 1% to 2% of the purchase price—is held in an escrow account until the sale is complete. 

The funds in a homebuyers escrow account typically go toward the down payment or closing costs. If the sale is successful, an escrow agent will release the funds and the property deed to the appropriate parties.

If the seller doesn’t meet certain conditions, like passing a home inspection, the buyer could back out of the deal and get their money back. However, if the buyer backs out of the sale without cause, the money might not be refundable. 

Once ownership transfers from the seller to the buyer, lenders typically require borrowers to have a mortgage escrow account. Lenders often manage mortgage escrow accounts to ensure that homeowners pay certain mortgage-related bills on time. 

Expenses like homeowners insurance premiums and property taxes are added to the homeowner’s monthly mortgage payment and deposited into an escrow account. The lender uses funds in the account to pay these bills on the homeowner’s behalf. Doing so could reduce the risk of late payments or liens against the property. 

In real estate, homebuyers and homeowners may both use escrow accounts. But there are some differences in the way each account type works.

If a seller accepts an offer on a home, both parties will sign a purchase agreement, and the buyer’s earnest money will be deposited into an escrow account. Earnest money is held in this account until the buyer and seller fulfill their purchase agreement terms, which may include:

• Completing a home inspection
• Having the home’s value appraised
• Getting approved for a mortgage
• Purchasing homeowners insurance
• Finishing any necessary renovations
• Conducting the final walk through

If both parties proceed with the sale, the funds in a homebuyers escrow usually go toward the down payment or closing costs. At this point, the closing agent will confirm that both parties have upheld their agreement. Then the agent will release the earnest money and close the escrow account. 

Keep in mind that some buyers and sellers include contingency clauses in their purchase agreements. In addition to an escrow account, these clauses could help protect one or both parties if the sale falls through. 

For example, a buyer might have a contingency clause that a property must pass inspection. If the home fails inspection, the buyer could back out of the deal and have their earnest money refunded. A seller may have a clause that requires the buyer to secure financing by a certain date. If the buyer fails to do so, the seller could put their house back on the market and keep the buyer’s earnest money.

Unlike a homebuyers escrow account, which is only active until closing, a mortgage escrow account remains open until the loan is repaid. A homeowners escrow acts as a holding account for expenses like:

• Homeowners insurance premiums
• Private mortgage insurance (PMI) premiums 
• Flood or wildfire insurance premiums
• Property taxes

Lenders generally collect these expenses as part of the borrower’s monthly mortgage payment. They keep the funds in a mortgage escrow and pay these bills on the borrower’s behalf. Having the lender manage these expenses can reduce the risk of missed payments, which could result in late fees or a lien against the home. 

Insurance premiums and property taxes can change from one year to the next. If prices rise and a homeowner’s escrow balance is less than the total expenses, the lender will typically cover the costs. But the lender might increase the homeowner’s monthly payments to make up the difference.

If you notice an increase in your monthly escrow payment, you could reach out to your lender for more information. Lenders are typically required to send borrowers an annual mortgage escrow analysis that includes a breakdown of charges.

And keep in mind that some escrow expenses, like PMI, may not be required if the buyer puts more than 20% down on a conventional mortgage or if they use a Veterans Affairs (VA) loan. 

Generally, a neutral third party known as an escrow agent manages an escrow account. Depending on a buyer’s location, an escrow agent may be a real estate attorney or a mortgage or title company representative. 

These agents hold assets in a homebuyers escrow until both parties have completed the terms of their agreement. They may also oversee the escrow process, review documents and confirm that the terms of an agreement are met. At closing, escrow agents may transfer money and property to the appropriate parties and create a new deed in the homebuyer’s name. 

With a homeowners escrow, agents may be affiliated with the buyer’s lender. They typically manage escrow funds and payments on behalf of the mortgage company and the buyer.

Thinking about buying or selling a home? If so, you may want to consider some of the potential benefits of using an escrow. 

• If the sale falls through, the buyer may get their earnest money back.
• Earnest money is often applied to their down payment or closing costs. 
• Mortgage escrows break insurance premiums and property taxes into monthly payments.
• A lender manages the mortgage escrow account on the homeowner’s behalf. 

• If the buyer doesn’t uphold the purchase agreement, the seller could keep the earnest money.
• Escrow ensures that a property doesn’t change hands before the sale is complete. 

• Using the account ensures payments are made on time and reduces lending risks. 
• Managing the account themselves may help avoid late fees or liens against the property. 

An escrow account can offer some protections throughout the homebuying process, but there are also some potential disadvantages to consider. 

• Setting up an escrow account may require an upfront deposit. 
• Escrow companies may charge additional fees for their services.
• Insurance premium or property tax increases could increase monthly mortgage payments.
• Putting money into an escrow account may limit the amount of cash a homeowner has on hand.  

Here are some answers to commonly asked questions about escrow:

Escrow is a financial agreement that allows a neutral third party to manage funds or property until the terms of an agreement are completed. In real estate, a homebuyers escrow and a homeowners escrow are the two types of escrow accounts that you might encounter. 

From safeguarding a buyer’s earnest money to reducing the risk of missed property tax payments, escrow accounts can offer protections for buyers, sellers and lenders. Speaking with a real estate attorney or mortgage lender may help you better understand your escrow options. 

Navigating the housing market may feel overwhelming, but researching your options can help. Thinking about buying a home but unsure where to start? You can read about some important questions to ask before buying a home.