What is escrow?
Escrow represents a legal concept that describes a financial instrument in which an asset (normally a property deed or escrow money) will be held by an autonomous, unbiased third party on behalf of two other individual parties who are currently in the process of completing an exchange or transaction. Escrow accounts will often include escrow fees which are managed by agents that hold the assets or funds until they receive appropriate instructions, or are informed that the predetermined contractual obligations have been fulfilled. Some assets that may be held in escrow include but are not limited to money, deeds, funds, and securities. Escrow is often used as an alternative instead of certified checks or cashier’s checks.
In order to receive a certified check from your bank, the money has to be drawn directly against your own personal checking account, this way your name and account number appear on the check. Once you sign the check a bank representative will sign it as well, and the words “accepted” or “certified” will be printed somewhere on the check. This means that the bank guarantees your account has the money and therefore the check is valid. It may be worth mentioning that the bank may put a hold on the funds used for that transaction until the check clears, similar to how a third party would hold the money until the conditions or obligations are filled.
On the other hand, with a cashier’s check, rather than having the money drawn against your checking account, it is drawn against the bank’s funds. To get the cashier’s check in the first place, you need to transfer funds (as well as a fee for the service) from your savings or checking account into the bank’s account. Afterward, a bank representative will issue the cashier’s check which will include the bank’s name and account information, the names of the payee and remitter will also be included. The funds will most likely be available to the payee the next business day.
Escrow is most often used when two parties are undergoing the process of completing a transaction but there is some sort of doubt or uncertainty as to whether one party or another will be able to fulfill everything they are expected to do according to the agreement. Escrow is typically used in real estate, banking, intellectual property, mergers & acquisitions, law, internet transactions, etcetera…
In an effort to provide a simple example, consider a company that sells its goods internationally. According to their agreement with the buyer, they will receive payment the moment the goods reach their destination. The buyer will pay for the goods as long as they arrive in good condition. In order to protect both of the parties interests, the buyer can place the funds in escrow through an agent with detailed instructions to release them to the seller after the goods arrive and pass a quality examination.
To summarize everything:
● Escrow represents the integration of a third party to oversee an exchange while holding the assets or funds until the exchange is completed in a way that satisfies both parties.
● Both parties are required to fulfill obligations stipulated by a contract in order for the third party to release the funds.
● Escrow is usually associated with real estate transactions, however, it can be used in any scenario where funds need to be transferred from one party to the other.
● Escrow can be used while purchasing a home, or alternatively during the life of a mortgage.
● Escrow can also be used to offer secure transactions for luxurious items, such as jewelry and art.
Escrow Accounts in Real Estate
When buying a home, the purchase agreement will generally not be complete without the inclusion of a good faith deposit (also known as earnest money). This deposit represents that the buyer is serious about acquiring the home. If the contract cannot be fulfilled for reasons pertaining to the buyer, the seller will usually get to keep the money. On the other hand, if the purchase is successful, then the money will be discounted from the buyer’s down payment, effectively giving them the money (as a lack of further cost). In order to protect both the seller and the buyer, an escrow account must be set up to hold the deposit. The earnest money (good faith deposit) will be held in the escrow account until the transaction is completed. After that, the deposit will be applied to the down payment (deducted). Occasionally, funds might be held in escrow past the date of completion for the sale of the property. This is known as an escrow holdback. There are plenty of reasons as to why an escrow holdback may be required. Perhaps the buyer found something wrong with the property while doing the final walkthrough (a final examination of the home by the buyer) or maybe they previously agreed that the seller could stay in the home for an extra month or two. When building a brand new house, the money needs to remain in escrow until both parties sign off on all the work. The moment that the agreed-upon conditions are met, the money will be released to the correct party.
Escrow Accounts for Taxes and Insurance
Once you purchase your home, your lender may assist you in establishing an escrow account in order to pay for your taxes and insurance. If your lender is not servicing your loan, a mortgage servicer could also assist you in establishing an escrow account. After closing, either the mortgage servicer or your lender will take a portion of your monthly mortgage payment and hold it in the escrow account until the payments for your tax and insurance are due. There will be some degree of variation in the amount required for escrow, and both your tax bill and insurance premium may change from year to year. With that in mind, your servicer (or lender) will estimate your escrow payments for the coming year based on the previous year’s bills. In an effort to be able to guarantee there is enough cash in the escrow account, lenders will generally require about 2 months’ worth of a payment to be held in your account, additionally to the rest of the payment.
Your servicer or lender will be analyzing your escrow account annually in order to ensure that they are not collecting too little or too much. Should their analysis determine that they have collected too much money for insurance and taxes, they will refund that extra money. On the other hand, should that analysis show that they have been collecting too little, you will need to compensate for that amount. Your servicer or lender may offer you options to either increase the amount of your monthly mortgage payment or make a one-time payment to compensate for the shortage in the escrow account.
How long does escrow take?
The escrow process usually takes anywhere from 30 to 60 days to complete. The time varies greatly depending on the agreement between the buyer and seller. The provider of the escrow may also influence the duration, among other things. Typically, the process will not take more than 30 days. If it does last more than 30 days, there might be some sort of issue in the process. Here we will be looking into some factors that will determine how long escrow takes.
● Pre-approval of your mortgage
● Required time for tasks
● Having proper documentation handy
● Escrow specific state requirements
● Time required to complete the underwriting
Having mentioned underwriting, it might be a good idea to go more into detail about what that entails. In escrow, underwriting is the process with which an individual or institution can take on financial risks, for a fee, that is. It assists in setting fair borrowing rates for loans, as well as establishing premiums. Ultimately, underwriting creates a market for securities by pricing investment risks accurately.
What is an escrow balance?
Should your mortgage be escrowed, your monthly payment would be split into three parts. Two out of the three would go towards principal and interest, depending mostly on your amortization schedule. “Principal” refers to the original sum of money committed to the purchase of assets (within your mortgage). As for “amortization schedule” it refers to the payment schedule for your loan. At first, the larger part of your monthly payment will cover interest, however, over time, more will be going towards your principal.
The remaining third of your payment will be going towards your escrow balance. In most mortgages, funds will be held in escrow in order to pay property taxes as well as homeowners insurance. The company servicing the loan will take the money out of your escrow balance to pay the bills when your taxes or insurance is due.
To sum things up:
● Most lenders generally require escrow accounts so they can successfully protect their investment and ensure that taxes and insurance are being paid for.
● Mortgage payments will generally include a portion to be held in escrow to pay property taxes and insurance.
● The company responsible for your escrow will be doing escrow analysis periodically, which could potentially cause your monthly payment to change.
● The money in your escrow account cannot be directly accessed by you, and banks usually do not pay interest on your escrow balance.
● Making additional principal payments can also help you save money on interest or adjust your payout plan.
● The more you pay toward the principal, the more equity you accumulate. Equity is a valuable asset that is frequently used to refinance a house loan. Equity rises at a slower rate in this case. However, take in mind that several loan programs have varying amortization periods. As a result, it’s critical to talk about your financial goals with your loan officer throughout the mortgage process.
While most mortgages will normally need or encourage an escrow account, not all mortgages will necessarily require one. Federal Housing Administration loans will always require an escrow account, however, this is not the case for all banks, as some of them do not. FHA loans require escrow in order to protect the bank’s investment in your property, as that is how they ensure that taxes and insurance continuously get paid.
It is generally a good idea to escrow both your taxes and mortgage/homeowner insurance even when it is not required in order to simplify budgeting for those expenses.
Mortgage principal and interest are paid in arrears, or after interest has accrued, unlike most other loans. As a result, when you buy a house, your first payment is due at the start of the first full month following the closing. Should you close on April 10, you will not have to make your first payment until June.
When you close in on your mortgage loan, however, the lender will be collecting interest for the remainder of the month. Should you close on the 15th of a 30-day month, you will be charged for those 16 days of interest — the number of days left in the month, which includes the 15th. This ensures that all payments are equal. The closer you get to a month’s end, the less interest you’ll have to pay that month. The closer you get to a month’s end, the less interest you’ll have to pay that month (as interest is prorated by day).
The most important takeaway:
As you might think, you pay all of the interest that is due at some point – neither more nor less. If you want to save money on closing fees, talk to your realtor about seller concessions or ask your mortgage lender about assistance programs.
At this point, it is clear that you cannot typically access money in your escrow balance, as that money is being held by either a loan servicing company or a lender on your behalf. Banks usually do not pay interest on your escrow balance. The total amount of money held in your escrow account is commonly included in your mortgage statement for the month, as well as in your online account information.
Lenders are required to regularly analyze the amount of money in your escrow account by the United States government. Most lenders will usually go through this process once a year, but they may require you to analyze your account more often should the amount that you owe for insurance and taxes change. By doing this they can effectively increase the chances of you fulfilling your contractual obligations, informing you of potential changes ahead of time with complete transparency for the reasons for those changes.
During these periodic escrow analyses, the lender will calculate the amount of money that will be due for homeowners insurance and property taxes during the following year. In order to illustrate this further, please take a look at the following example:
● January — $3,450 due for semiannual property taxes
● April — $1,500 due for hazard insurance
● July — $3,450 due for the second half of property taxes
Your expected yearly outlays would then be $8,400, which the lender would divide by 12 in order to get a $700 monthly payment towards your escrow account. Due to government regulations, you may also be required by escrow companies to maintain an extra amount of cash in your account to act as a cushion should unexpected payments arise. Because of this, your monthly payment may be higher than the amount you originally ended up with after dividing $8,400 by 12, for example, one month it could end up being about $900.
What are escrow fees?
Escrow fees are a portion of the closing costs that need to be covered when you purchase a home, they are paid to either the title company or directly to the escrow company in order to set up escrow for your earnest money (good faith deposit). These fees are needed to cover all sorts of paperwork, including but not limited to the recording of the deed and the exchange of funds. Having an escrow account in place comes in clutch during the closing process as it helps keep your good faith deposit safe.
Here are some specific costs that are typically held in escrow:
● Seller’s profit
● Loan fees
● Real estate fees
● Third-party payments
The use of an escrow account to hold these costs could be compared to using a savings account to keep yourself from spending money you should not be spending in the first place anyways. It is also worth mentioning that escrow fees will not be the only closing costs that you will need to pay, so make sure you understand and prepare in knowing what other expenses will be required before you can own your new home.
What is an Estimated Escrow?
An estimated escrow is an estimated monthly cost of your property taxes and homeowner’s insurance. As was previously mentioned, it is calculated by your lender and can vary from month to month. Calculating estimated escrow is relatively easy, as we saw earlier, to get a rough estimate for your monthly payment all you need to do is add the total property tax and homeowners insurance bills for the year, and then divide it by 12 months. The variations are made by the changes in property tax and insurance premium rates that increase or decrease after the original calculation.
The formula for calculating escrow is simple. The figure is used to compute the total tax and insurance bills for the coming year, which is then divided by the number of payments every year. The increased funds will subsequently be used to pay the mortgage payment. After this calculation, any changes in insurance premiums or property tax rates will affect the amount of escrow added to the mortgage payment. This calculation is carried out once a year. Some lenders will additionally provide an “escrow cushion,” which is a financial amount put to the account to help prevent shortages.
Final Comments and Conclusions:
Escrow is a powerful tool that can assist in smoothing out transactions while protecting the assets and parties involved with those transactions. It is especially useful for aspiring homeowners, as by using it correctly you can avoid falling into debt through ease of payments and you can lower the overall interest that you would regularly pay on your loan, giving you not only peace of mind but benefiting you financially. An additional benefit is that it is automatic and there are no surprises, further reducing your potential distress and saving your time, which is ultimately the most precious of all your resources. Hopefully, by reading this article you will have an easier time with them more often than the not difficult process of purchasing a home. Make sure you talk to multiple lenders in order to get the best rate on your loan before fully committing.
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