If you are a first time home buyer, the process from signing that first sales contract to sitting at the closing table can be intimidating. There are many considerations that must be addressed before you receive the keys to your new home. Hopefully, you have a trusted real estate agent by your side to help you navigate the unknown territory, but it is also important that you school yourself on the ins and outs of real estate deals. In this article, we tackle the often foreign and typically confusing topic of escrow. If you are buying real estate, escrow is necessary, and we tackle this subject head-on in the following article.
What Is Escrow in Real Estate?
When referring to escrow in buying real estate, there are actually two forms. In both forms, escrow is the idea that a neutral third party is involved in order to protect both players in a major financial transaction. The first time you will encounter escrow with real estate is during the purchasing process before you close on your property. The second form of escrow that involves real estate is when a lender holds funds on your behalf in a separate account to pay the real estate taxes and insurance that will be due on your home each year.
During The Purchase of a House
After you have found that perfect home, and the seller has agreed to the terms set forth by the sales contract, your realtor will set up what is called an escrow account. This account is operated and controlled by an objective third party, and this is typically a title company. It’s important to choose a reputable title company, and your real estate agent will be key in doing so. Choosing a reputable agent and title company is key in buying real estate.
When you agree to purchase a home, there are still many steps that have to be completed before that sale is final. In addition, along with the signed contract, the seller expects you to deposit between 1% to 3% of the sales price into an escrow account. This assures them you are serious about the purchase and aren’t intending to back out of the deal. This escrow account is established by your realtor and is maintained by the title company, and funds will not be released from escrow to the seller until closing.
After Purchasing a House
Once you have closed on your home, more than likely, you obtained a loan with a mortgage company that allowed you to make the purchase. This lender depends on you to pay down the mortgage, and if you don’t, they can foreclose the home and take possession. It is in the lender’s best interest that the home remains insured and that the taxes are paid and up to date.
If they have to take the home from you, they do not want to deal with back taxes or any damages or issues that have arisen because you did not keep the house insured. To ensure that these two vital items are addressed, the lender will require you to include payments for real estate taxes and homeowner’s insurance in your monthly mortgage payment. This typically works by them breaking up the estimated taxes and insurance into twelve payments and charging you this amount each month. This amount is added to your mortgage payment.
How Does Escrow Work During a Home Purchase?
There are many facts you need to know about both forms of escrow when buying real estate. Knowing the definition of escrow is not enough to prepare you for closing and in mortgage repayment. There are steps to follow for each form, and rules and regulations that protect you, and we have listed these below.
The Step-by-Step Process of Escrow
If you’ve ever purchased a home, then you know that the process is long and tedious. There are many steps that have to be completed before you officially become a homeowner. Once you and your realtor have found that perfect home, you will work with them to formulate a purchase agreement. In this, you will spell out what you agree to pay for the property and under what terms. This is presented to the seller, and if they agree, then a sales contract is completed.
The sales contract will spell out all the details and expectations of both parties before the sale is final. One of these details is how much you the buyer will deposit into escrow. Typically this amount is between 1% and 3% of the sales price and can be negotiated. For your protection, this money does not go directly to the seller but is held in an escrow account by a third party. Your real estate agent will take your check and deposit it into an account that is managed by the title company. This money is held there until the closing date.
Things to Watch Out For When Using an Escrow Account
A common question that arises when buying real estate is, if I change my mind, can I get my escrow money back? The answer is no unless you are asking for the money back because of a specific contingency spelled out in the sales contract. A contingency says that if “x” happens, then the seller can back out of the contract and receive their escrow funds back. Such contingencies usually include financing falling through, the property not appraising, or problems that arise during the home inspections. If this happens, you can usually have both the buyer and seller sign a Cancelation Release Form.
How Does Escrow Work for a Mortgage?
If you are not investing at least 20% down on the purchase of your new home, you are guaranteed to be funding an escrow account to cover your real estate taxes and insurance. You will be given the details of your escrow account at the closing table (and before to review) in a document called HUD-1. Lenders are required to provide this document to you before closing. This document will spell out the terms of your escrow account.
Typically, banks will require six months of the amount needed for your taxes and insurance to remain in the escrow account, and most require a cushion. This cushion cannot be over 1/6th or two months of escrow funds, according to the Real Estate Settlement Procedures Act. While this amount is spelled out on the HUD-1 form, there is no guarantee that this amount will stay fixed. Rising insurance costs and increased taxes could cause the amount required for escrow to increase. Typically your escrow balance and amount needed are reassessed by your lender once a year, and changes are made as needed.
Buying real estate can be confusing, and it’s important to research the process for yourself. By knowing the definitions and forms of escrow, you have jumped one large hurdle in the race to becoming real estate savvy. So next time you consider that next real estate purchase, go in armed and ready with your knowledge of escrow. It will make you that much smarter and less likely to make a rookie mistake.