Types of Escrow Accounts
Escrow is one of those financial terms that most people don’t hear every day. But the concept doesn’t need to be intimidating. Escrow accounts serve several basic needs, and we’ll cover each of them here.
An escrow account is an account designed to safely hold funds temporarily. The escrow provider should be a disinterested third party with no preference about who ultimately receives funds from the account. For example, in a real estate transaction, the escrow account does not belong to the buyer or seller. Escrow accounts are useful in several ways:
- Homebuying: An earnest money deposit should stay in an escrow account to protect both the buyer and seller.
- Monthly payments: A homeowner might make deposits into an escrow account with each monthly payment, helping to smooth out large annual expenses.
- Renters and landlords: Escrow accounts can be helpful for protecting the interests of renters and settling disputes.
- Buying goods and services: Escrow is an option for almost any transaction where buyers and sellers want a “referee” to oversee payment.
We’ll cover each of those in more detail, but the common theme is using an account to hold money for safekeeping.
Buying or Selling a Home
Most people get their first exposure to escrow when buying or selling property. When making an offer, you often include an earnest money deposit to show the seller that you’re serious about buying. But you don’t want to just give money directly to the seller—you’d have to trust that the seller is financially secure, honest, and organized enough to return funds to you if the deal doesn’t work out.
Buyers typically make earnest money checks payable to an escrow or title company. Doing so allows the seller to receive funds if you back out unexpectedly. At the same time, you can be confident that you’ll get your money back if there’s a problem with one of your contingencies (for example, you find something unacceptable at inspection).
The escrow provider should not care whether the buyer or seller gets the funds (although they might prefer to see the deal go through). They review your purchase offer and either return funds to the buyer or send funds to the seller, depending on who is entitled to the money.
When you borrow money to buy a home, you may have to use an escrow account for monthly payments. Expenses like homeowners insurance and property taxes are often annual expenses, but most people think about monthly payments—and large annual bills catch them by surprise:
- Smoothing expenses: To make those significant expenses more manageable, lenders often require that you save a portion of the annual amount each month. With each monthly payment, your funds go toward your loan balance (principal and interest) as well as your taxes and insurance. Those payments are often called PITI payments. With each monthly payment, the amount for your taxes and insurance goes into an escrow account until annual bills come due.
- Required or optional? Some lenders require that you use an escrow account. Even if they don’t, you might decide to voluntarily use one to break your annual expenses into more manageable pieces. By spreading out the payments, you don’t have to scramble for funds when a significant bill comes in. Lenders often like to use escrow accounts because failing to pay taxes and insurance bills puts them at risk. If your house burns down, they want to get their money back, and taxing authorities may put a lien on your home (making it hard for you and the lender to sell).
- Do it yourself? If you don’t have an escrow account to smooth out payments, plan ahead. Expect to pay property taxes once or twice per year, and decide how to pay for homeowners insurance. You may be able to pay monthly (on your own), or you might just choose to pay the full amount in a lump sum.
- Best use of the money? You might worry that you can earn more on your savings than you get from an escrow account. That may be true, but evaluate the numbers with a critical eye. How much do you keep in your escrow account at any given time? Especially when interest rates are low, any extra earnings you might get at the bank of your choice won’t amount to much. Is it enough to move the needle on your finances?
Escrow Accounts for Renters
When it comes to renters, escrow may be useful in two ways. But check with a local real estate attorney and state regulators to confirm how things work in your area.
- Security deposits: In some states, landlords must keep security deposits in an interest-bearing escrow account. That practice ensures that renters get their money back—and that funds are available to make repairs if needed. If landlords just deposit funds in an operating account, it’s easy to lose track of the money and spend it on other needs.
- Disputes: When landlords fail to address renter needs (like the need for running water or heat), renters might be allowed to withhold rent payments. But in some states, renters are required to deposit the regular rent payment into an escrow account. Doing so protects the landlord and shows that they’re not just trying to avoid paying, they just want the services they’re paying for.
Escrow accounts can help to facilitate almost any kind of transaction. By involving a third party to hold funds in safekeeping, buyers and sellers can feel confident about doing business. For example, when buying or selling online, you don’t know the person or company on the other end of the deal. If you’re concerned about getting ripped off, several online services can perform escrow duties for you.