The process of buying a home can be confusing. You’ll hear a lot of terms being tossed around— some that you may understand and some that may leave you scratching your head. 

Escrow might be a term that sounds like a foreign language to many first-time homebuyers.

Escrow Explained

Escrow is a legal arrangement that describes a situation in which an impartial third party holds onto something of great value until a transaction has officially been made. 

In terms of buying a home, escrow refers to the money that you will give to a neutral third party– an escrow service– and that third party will hold onto the money until both you and the seller of the property have successfully negotiated and finalized the purchase. The money you furnish is known as earnest money.

The money that’s placed in escrow cannot be touched by either you or the seller until after the deal has been sealed.

The Different Types of Escrow Accounts 

In the realm of real estate, escrow is used for two main reasons:

  1. To secure the homebuyer’s good faith deposit in ensuring the money goes to the correct party, according to the sale conditions that were previously laid out.

2. To hold a homeowner’s assets for insurance and taxes.

Because escrow can serve different purposes, there exist two types of escrow accounts. One is utilized during the home-purchasing process, whereas the other is used throughout the span of your loan. 

Escrow for Buying a Home

When you’re endeavouring to buy a home, the purchase agreement you make will typically include a good faith deposit (what we’ve previously defined as “earnest money”). This shows that you are serious about buying the home. If the contract that’s been agreed upon falls through due to the buyer’s fault, then the seller typically gets to keep this money. If the contract is successful, the money goes toward the buyer’s down payment.

In the interest of both the buyer and seller, an escrow account is set up to hold the earnest money. The deposit will remain in the escrow account until the transaction is completed. Then, the money is applied toward the down payment.  

Escrow for Taxes and Insurance

After you’ve purchased your home, your lender may offer to establish an escrow account for the purpose of paying your taxes and insurance. After closing, your lender (or mortgage servicer) will transfer a portion of your monthly mortgage payment and hold it in escrow until your taxes and insurance payments are due. 

Since your taxes and insurance premiums can change on a yearly basis, the amount required for this type of escrow account is a moving target. Your servicer should determine what your escrow payments will be for the next year based on the bills that were paid the previous year. Most lenders require about two months’ worth of extra payments to be held in your escrow account to ensure that there’s enough cash for all your bills.