Deciding to buy a house is easy. Saving up for and selecting the right house is a rewarding challenge. Wading through the actual buying process, however, is something most first-time home buyers are not prepared for. By necessity, buying a house is a multi-step legal and financial process. There are assurances and securities on both sides, for buyers and sellers, to make sure the deal goes through legitimately. It is necessary to include a contract, lawyers, and a special bank account known as escrow to make the deal happen correctly.
What is escrow? Buying a home is the first and only time most people come across the term. Put simply, escrow is when a neutral third party holds money or valuables during a transaction. This is where your earnest money goes. Let us break down what escrow is, how it works, and what first-time home buyers should know before putting earnest money into an escrow account.
What is Escrow?
Escrow is a type of financial transaction that protects both parties from outright thievery, where money or property is held by a neutral third party. Real estate, by nature, deals in high-value property and large sums of money changing hands. This creates a feeding trough for scam artists looking to grab a bag of cash and run and those with more nefarious plans.
When money is put on the table, it’s important to protect it from mad-dashes from either party. So it goes into Escrow. This means that some impartial person or bank holds the money for both parties in the transaction. The money can then only be accessed for the original, pre-agreed purposes. It’s safer for everyone and prevents the most common types of real estate scams.
Escrow and Earnest Money
The tradition of escrow in real estate is most closely tied to the need for earnest money in a high-value sale. Also known as a good-faith deposit, earnest money is the buyer’s investment in the purchase. When a buyer opens negotiations., the seller takes a good-faith action and pulls the house off the market. This is an investment, in its way, because of the potential cost to put the house back on the market if a deal falls through.
A buyer puts down 1% to 3% of the home’s listed price as earnest money. This money will eventually go into their purchase amount, eventually applied to your homeowner’s insurance and property taxes, unless the deal falls through. If the deal falls through, the seller keeps the earnest money to cover the costs of re-listing.
So who gets to hold the earnest money?
If the buyer holds it, they could just back out without consequence. If the seller holds it, they could cancel the deal and scam buyer-after-buyer out of their earnest money.
That’s where escrow comes in. A neutral third party, usually a bank, is given the money to hold. Neither party can drain the account and run, and terms must be confirmed before the money is put to intended use. This means buyers can give a good-faith deposit on their intention to buy and both parties are protected from the possibility of opportunistic thievery.
What to Know When Buying a House
- Your earnest money goes into an escrow account, which is the safest place for it to be
- The earnest money in escrow will be used for your first homeowner’s insurance and property tax expenses
- The terms “escrow”, “impound”, and “reserves” are used interchangeably by lenders but they all mean the same thing. In other words, they’re putting your money in cold storage until the terms of the contract reach a conclusion
- Sometimes the term “prepaids” is used when talking about insurance and tax expenses, and the use for escrowed money
- Closing of Escrow means confirming the contract and dispersing the earnest money. This is often done by an escrow officer, a lawyer or financial professional
- Sometimes escrow is also used for special negotiation terms like rent-back and final costs
If you have any questions or want to discuss more options, reach out to me, your local expert Loan Officer.