What is escrow and how does it work

Escrow is an additional guarantee for both sides of the deal

ESCROW

What is escrow and how does it work. Source: shutterstock.com

When it comes to payments that don’t bring immediate value, the matter of mutual trust becomes more acute. Long gone are the days when the purchasing process was limited to the face-to-face exchange of goods for money.

People are used to remote online shopping. They use long-term partial payment options to finance expensive purchases like movable and immovable property. Digital goods, services, and even ideas can be sold. There are many situations when closing the deal takes some time and lots of documentation.

Simultaneously, those who buy and sell often neither meet in person nor have previous interaction experience that can bring out loyalty and trust. Therefore, both sides of the deal need some additional guarantees that no fraud will take place before they finalize a transaction. Here is when escrow comes in handy.

Escrow is a typical financial scheme with an impartial intermediary involved to regulate monetary or asset exchange between the two interested parties of the purchasing deal. This “perfect stranger” controls whether the agreement is kept on both sides and transfers money accordingly.

Depending on the reason for the escrow application, the escrow agent may be a title company that specializes in real estate, a bank or other certified financial institution, or a private individual entrusted with the role of intermediary.

The contexts where you can meet the term “escrow” include retail, banking, intellectual property, real estate, mergers and acquisitions, law, and many more. For instance, M&A use a holdback escrow mechanism for both asset and stock transactions where a share of the purchase price serves as security for the buyer. The reliable purchase process is particularly important since M&A deal with big sums of money.

Originally, this word meant a written note or a contract saved with a third person until a future condition is satisfied, which led to the new sense of the “deposit held in trust or security”.

Usually, when we mention escrow in modern financial contexts, we presume having a secure account needed for mediating the transaction.

What is an escrow account?

Bank Pekao

Banks and escrow agents can open this type of account for their clients. Source: shutterstock.com

This neutral bank account or e-wallet is the place where funds are stored by a trusted third party while two or more deal participants fulfill their obligations as agreed and accomplish a transaction. It holds valuables, such as money, property deeds, securities, or personal finance documents.

Banks and escrow agents can open this type of account for their clients.

When it comes to using escrow for buying property, this savings account is managed by the mortgage servicer. The latter will deposit a portion of each mortgage payment into your escrow account to cover estimated real estate taxes and insurance premiums.

Renting a place may require an escrow account too. Thus, a landlord’s escrow bank account holds security deposits in a neutral location to make sure the funds are accessible when tenants move out. States that don’t require a separate escrow account often require landlords to place security deposits in a regulated financial institution.

In retail, an escrow account is temporary storage for the purchase costs. Money stays there for a while and transfers to the seller’s account only upon approval. If the buyer rejects the merchandise, the return process takes place.

What is escrow when buying a house?

While the property is on escrow buyers and sellers have plenty of things to clarify. Source: shutterstock.com

When a prospective buyer intends to buy a house, they often make an earnest money deposit to show the seller that they’re resolute in their buying decision. It represents a buyer’s good faith and will to buy a home. The early deposit gives the home buyer extra time to get financing, conduct the title search, property appraisal and due inspections before closing. As a rule, it’s 1-5% of the purchase price. When the deal gets finalized, this amount is put toward the total costs.

Sellers tend to favor these good-faith gestures too, because they want to ensure that the sale won’t fall through. If the buyer isn’t serious enough and rejects the deal without any reason, they may be able to keep this earnest money (depending on their agreement).

However, people often don’t want to give money directly to the seller. They don’t know each other well to trust that the seller is financially secure, honest, and organized enough to return the deposit if the deal doesn’t work out. Hence, escrow accounts are used for this purpose.

While the property is on escrow, hence, off the market, both buyers and sellers have plenty of things to clarify. With professional help, the buyer needs to check the house condition, discuss the bearing of damage repair costs (if the inspection reveals major problems), confirm the legal status of the title, etc. Furthermore, they need to consult with the lender once again if the house appraisal appears too low.

Another example of escrow usage in real estate sales is for the convenience of the mortgage lender.

Why does a mortgage lender escrow funds?

For ordinary consumers, mortgage escrow is one of the most confusing aspects of loan servicing. Meanwhile, in 2017, only 21% of the US population who bought a home paid the whole sum at once for their purchase. The statistics are similar in 2018 – 78% of all property deals involved a mortgage. Interestingly, 99% of homeowners with escrow have a mortgage on their properties.

When you borrow money from a bank or a direct mortgage lender to buy, build or refinance a home, they normally deposit the part of your monthly payment in the escrow account. That sum covers taxes and insurance premiums applied to your property. Some homeowners are required to have an escrow account by their lenders; others may opt-in.

This requirement helps lenders make sure their mortgage protection on the loan stays strong. Automated taxation will prevent the tax authority from placing a lien on the property that would negate the lender’s security of the loan. In addition, if the insurance is neglected and the house burns down or is flooded, the whole system of the lender’s protection is destroyed. Therefore, keeping your house undamaged is critical for any mortgage service.

Societe Generale

Your initial escrow payment amount is based on the property taxes of the previous owner. Source: unsplash.com

Your initial escrow payment amount is based on the property taxes of the previous owner. If you have had a house built, the initial escrow deposit will be based on the taxes on the unimproved lot. However, both property taxes and insurance premiums aren’t written in stone. They are permanently revised and subject to changes. The reasons may be different: new governmental policies, natural cataclysms, home-improvement projects, nearby construction or adding of some amenities in the neighborhood, etc. The bottom line is the value of your home isn’t fixed. The longer the term of your loan servicing, the more changes you can expect. Escrow agents review your escrow account annually to adapt the same for your fluctuating needs.

You’ll get a notice from your lender in writing when they need to increase the escrow component of your repayment. In that case, you should discuss available installment options with a loan escrow specialist.

Mortgage escrow guarantees that relevant bills are paid timely so that buyers avoid penalties. Depending on the policies of your lender, you may also get a discount on your interest rate or closing costs just by opting-in to an escrow account.

On the other hand, many buyers seek ways out of mortgage escrow. Some people may prefer to have more of their liquid cash work for them. It is risky, but possible. In the best-case scenario, if you wisely invest the same amount of money that goes into escrow each month, you’ll not only be able to pay the bills, but you may also generate some nice income.

Nevertheless, many banks will not allow you to remove that option if your loan balance exceeds 80% of the home’s appraised value. Banks may also require your mortgage to be of a certain age, at least six months old, for example. Moreover, if you have a governmental backed FHA loan designed for low-to-moderate-income borrowers, escrow accounts are a must. Due to the low credit scores of the borrowers, additional security is required by the lender. These loans come only from the FHA-approved lenders that bear less risk because the FHA will pay a claim to the lender if you default on the loan.

Escrow on marketplaces

At e-marketplaces, the customer obtains goods or services by transferring money to a third-party solution rather than sending it to the beneficiary recipients. It protects all those concerned from credit card chargebacks and scams as well as ensures that your purchase completes smoothly.

This way, the client is in control of their funds that are withheld until the client agrees that the product/service has been successfully delivered. Usually, there is an agreed-upon term during which the client can check the quality and report any problem with the product/service.

Many escrow-related API solutions also allow sellers to submit listings, review offers and negotiate prices with potential buyers, while the money is already deposited. Unlimited escrowing time, vigorous ID checks, set payout timing, comfortable checkout experience and more – these are some of the reasons why marketplaces use third-party escrow solutions for their sales.

Escrow also facilitates handling returns making sure money is not withdrawn by a seller before the customer is completely satisfied. The increased sellers’ dedication to the quality of their offers is a nice bonus of this approach too.

Improved mutual trust and security come as a result of a smart escrow integration into the marketplace payment gateways.

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