What is Escrow, and How Does it Affect Real Estate Transactions?

Example blog post alt

If you’ve never purchased or sold real estate before, there is going to be a lot of terminology getting thrown around that you probably won’t understand. A lot of these terms are from England and France in the years before the United States was even a twinkle in George Washington’s eye, but we continue to use them here. One such term is “escrow,” and although being in escrow sounds rather medieval, don’t be intimidated; it’s actually a very helpful mechanism for protecting the interests of both buyers and sellers.

Escrow Defined... a Couple of Times

One of the things that makes escrow a difficult concept for a lot of people to understand, is that it can have different meanings in different jurisdictions, and even different meanings at various stages of a transaction in the same jurisdiction.

The first time that escrow usually comes up in a real estate transaction is when the buyer deposits their earnest money payment. Earnest money is a good faith deposit by buyers that essentially serves to say “I am serious about continuing to negotiate for the purchase of this property.” However, even when both parties are serious things can, and often do, fall apart anyway. For that reason, the earnest money goes into escrow, which means it is held by a neutral third party (often a lawyer) instead of going to the seller themselves. The earnest money stays in escrow until the deal closes, at which point it is usually credited toward the purchase price of the property. Because the money is held by a neutral party up until closing, neither party has to worry about the other taking the money and running from the transaction, which offers peace of mind during the negotiating process.

Next, you will hear the term “close of escrow” come up when you finally finish negotiating and close on the transaction. To put it simply, the seller deposits the deed with an escrow agent (again, usually a lawyer), and the buyer transfers the remaining purchase price to that same escrow agent. When all conditions of the closing are satisfied, the escrow agent releases the funds and documents to the appropriate parties, and usually also records the deed. This has the same obvious benefit as placing the earnest money in escrow: the buyer never has to worry about giving the seller a huge sum of money and never receiving the deed, and the seller has no fear that he will give the deed to a buyer who never pays.

Finally, escrow is often used to describe an account maintained by the buyer’s mortgage lender after the transaction has closed and the buyer is living happily in their new home. This account, also known as an impound account, is paid into by the buyer along with their monthly mortgage payments each month. At the end of the year, the lender takes the money in the escrow account and makes the annual payment for the buyer’s homeowner’s insurance and real estate taxes. This account benefits the lender and buyer, because both parties have an interest in the property, and therefore also have an interest in the insurance and property tax payments being made on time.

What Escrow Does for You When a Deal Falls Through

Under the best of circumstances, you will be using escrow in the ways described above. However, escrow also exists to protect the parties when a deal doesn’t come to fruition and “falls out of escrow.”

Real estate sales fall through all the time, often because the sale is contingent upon the buyer getting financing which they then fail to do, or because purchase was conditioned on the seller repairing certain material defects before closing and they never do. Escrow helps to take some of the sting out this type of situation, by making sure the earnest money goes to the appropriate party.

Who gets the cash when a deal falls through is usually determined by the parties ahead of time by contract. For example, the parties might agree that the buyer gets his money back if the seller is responsible for the transaction not closing, and the seller keeps the money if the buyer causes the deal to fall through. Without escrow, you risk the other party backing out or causing the deal to fall through, and then running off with the earnest money, too!

In Closing

Hopefully, you now have a good understanding of how escrow works and why it’s such a good idea for both parties to a real estate transaction. At the very least, though, I hope you now have some idea of what escrow is! If you have additional questions, I recommend speaking with a local lawyer who can give you detailed information and advice.