The Role of Escrow Accounts in Real Estate Transactions

 man and woman discussing the escrow process

You have probably heard home buyers, sellers and real estate professionals talk about being in escrow, close of escrow, or even “falling out of escrow.” What do these terms mean, and how will they impact your home buying journey?

What is an Escrow Account?

An escrow account is a deposit of funds, a deed or other asset that one party to a contract will deliver to another party upon completion of a specific condition or event. The account is managed by a third party who is independent from the transaction. The most common form of escrow accounts are the ones used in real estate transactions.

Type of Escrow Accounts

There are two types of escrow accounts that are part of the homebuying process: The real estate, or pre-closing escrow account, and the mortgage escrow impound account.

  • Mortgage Escrow Account, is an escrow account, sometimes called an impound account depending on where you live, that is set up by your mortgage lender to pay certain property-related expenses on your behalf. If your loan includes an escrow account, you will pay monthly installments for taxes and insurance along with your monthly mortgage payment. Your mortgage servicer will deposit these monthly installments into the escrow account. Then, your servicer uses the funds to pay your bills when they come due, typically once or twice per year.
  • Real Estate Escrow Account, also called pre-closing escrow accounts, are held by third party entities separate from both the buyer and the seller, and are designed to protect the interests of both. These accounts hold all funds, instructions and paperwork necessary for the impending real estate sale, including funds for the down payment and the deed to the home. The rest of this post concerns this type of escrow account only.

Why Do You Need a Real Estate Escrow Account?

An escrow account provides protection for the seller, buyer and lender in a real estate transaction. It does this by ensuring that no funds or property will be transferred until every escrow term and condition have been met. For example, an inspection shows that plumbing repairs are needed, which the seller has agreed to as an escrow condition—but does not actually complete. Because the funds are held in this type of account, the buyer has the power to stop the sale process if the repairs are not completed.

How Does the Escrow Process Work?

The buyer, seller and lender work together to draft the terms of the escrow agreement. This document is then signed by all parties and is sent to the escrow agency, a third party that is separate and distinct from your lender. It is here that the escrow officer will process the funds and documents in accordance with the escrow instructions.

Worried about how and where you, the homebuyer, should open an escrow account? It’s not something that you need to be concerned about: Generally, the buyer's or seller's real estate agent will open the escrow account and you may have the right to choose your own escrow holder (depending on local custom). After your offer has been accepted and you have completed the Purchase Agreement, your real estate agent will place an initial deposit (usually your earnest money, or about 1% to 2% of the purchase price) in this escrow account.

Typically, the buyer (or an agent acting on behalf of the buyer) will instruct the escrow officer to release funds only when all conditions have been met, title insurance has been issued and the seller's deed has been signed. Escrow is not complete until all the terms have been fully satisfied and all the parties have signed the appropriate documentation.

Who Distributes Escrow Funds, and When?

The process of buying a home can be a long one. Disbursing the funds and closing the escrow account is one of the last steps. In fact, this is why the meeting at which the signing of the final paperwork occurs for your home purchase is called the “closing.” After both parties have signed all the necessary instructions and documents, the escrow officer will return the buyer's loan paperwork to the lender for final inspection.

Once this step is complete, the lender will then grant permission to fund the buyer's mortgage, and the funds are transferred from buyer to seller and the empty escrow account is then closed. An escrow closing marks the end point of the real estate transaction, and it represents the legal transfer of title from the seller to the buyer. All documents and funds have been collected and properly disbursed, and you—the buyer—now own your home.

What Happens to Escrow Money if the Sale Does Not Happen?

A real estate sale might not close for a number of reasons, such as a buyer not being able to fully qualify for a mortgage, or the discovery of previously unknown issues with the property during the home inspection. If this happens, the sale “falls out” of escrow. What then happens to the escrow funds varies based on several factors, such as who was “at fault” for the failure.

If a buyer backs out of a sale (without a good reason like an inspection finding), the earnest money that they deposited into the escrow account may go to the seller. If the sale is cancelled by the seller (or the seller’s actions), the buyer’s funds will typically be returned to them. Most purchase agreements contain details on what will happen to the escrow funds in a variety of situations - make sure that you read yours carefully!

A Safe Place for Buyers and Sellers

Whether you are buying or selling a home, using an impartial, third party escrow account to hold your funds is essential. Escrow protects all parties as they go through what will probably be one of the largest and most complex transactions of their lives.