Understanding Escrow and Why It’s Important

Escrow plays a crucial role in real estate and financial transactions by ensuring trust, accountability, and organization between all parties involved. Whether you're buying a home or hiring a contractor, understanding how escrow works can protect your interests and simplify complex deals.

• Escrow is a neutral third-party service that holds funds and documents until contract terms are met.

• Common uses include home purchases, mortgage payments, rental deposits, and construction disbursements.

• Escrow accounts offer protection, prevent disputes, and help ensure all financial obligations are fulfilled properly.

The use of escrow services and accounts is probably familiar to any mortgage borrower who has ever bought or sold a home in California. In 1974, fewer than half of all U.S. home mortgages used a third-party escrow account or agent. These days, more than 80% of all residential transactions were completed with a neutral party handling the escrow. But what is escrow, and why is it used in real estate transactions, and more? At The Police Credit Union, we want you to understand every step of the home buying process, so learn more about escrow so you can increase your financial savviness. 

A kind of good-faith, surety tool

The term escrow has been in use for more than a century as a financial tool to facilitate the exchange of money and documents between real estate buyers, sellers, and their financiers. In simple terms, it’s a service or account provided by a neutral third-party, such as an escrow company, lawyer or notary, mortgage lender or servicer, or title agent. Interestingly, the term escrow has many different purposes:

• Mortgage servicers remit a portion of your monthly house payment into escrow, also known as a “mortgage impound account,’’ to cover your home’s property taxes, private mortgage insurance, and hazard insurance.
• In some cases, homeowners’ association fees are escrowed.
• Landlords place renters’ security deposits in escrow.
• Housing courts frequently use escrow in the settlement of tenant-landlord disputes.
• Escrow is also deployed for the payment of general contractors and subcontractors on construction projects.

Think of it as a kind of surety tool that ensures parties on both sides honor in good faith their commitments and obligations in a deal.

And in a digital era in which more property sales, lending applications and decisions, and fund transfers occur remotely via the internet, it helps to understand the role escrow plays in our global economy.

Escrow keeps deals organized and on track

Banks and credit unions typically do not charge fees to set or administer escrow accounts for mortgage or construction loans they originate.

These third parties collect and hold funds, deeds, title papers, and other vital documents until the buyer and seller have fulfilled all the obligations under their agreement. Escrow offers these benefits:

• That all parties involved uphold the terms they agreed upon
• That the paperwork is kept in order
• That the funds for each party are accessible

In that way, escrow is essentially protection, enabling both sides in a transaction to hold the other accountable for upholding their end of the deal. It’s also a mechanism for exchanging funds or other valuable considerations once the deal terms and conditions are met.

Many states mandate that escrow agents be licensed, including California. Escrow agents, too, are required to stay at arm’s length in transactions, to avoid impropriety. For instance, a real estate agent or lawyer representing you in a transaction cannot oversee your escrow.

Escrow accounts take on different forms

While many consumers know or have encountered escrow accounts and services when buying or selling a home, what you may not know is how frequently and widely escrow is applied to a cross-section of industries and transactions.

• Real Estate Sales Escrow: You’ve made a firm offer to buy your dream home, backed up with an earnest-money deposit that’s immediately put into an escrow account where it remains until closing. Later, if you change your mind and back out of the deal, you may forfeit all or part of your escrow deposit, depending on the terms of your purchase contract. If the seller backs out, your earnest deposit is returned to you.
• Mortgage Escrow: If you’ve ever financed your home with a mortgage, your lender or mortgage servicer – the entity assigned to collect your monthly payment – most likely established an escrow account to hold a portion of your house payment earmarked to cover your property taxes, association fees, and mortgage- and hazard-insurance premiums. Your mortgage escrow balance may fluctuate annually, depending on         increases or decreases in your property-tax assessment, owner-association fees and insurance coverages. If your balance falls into an “escrow deficit,’’ your lender or servicer will raise the escrow portion of your house payment to adequately cover those outlays. Conversely, if your mortgage escrow balance reaches surplus because your lender/servicer overestimated your escrow payouts, you can either keep the surplus in escrow or request the overage be redeemed back to you. Banks and credit unions are not required to pay interest on escrow deposits.
• Renters Escrow: Landlords usually insist that tenants advance one or more months of rent, or that pet owners put up a deposit as security against damage or undue wear and tear. Those deposits are placed in escrow to be returned in full, in most cases, to tenants when they move or the lease expires.
  Escrow can also be vital in resolving disputes between tenants and landlords. With oversight from a court or judge, rents from aggrieved tenants are temporarily placed in escrow until the dispute, typically involving the need for serious repairs to a property, is resolved.
• Construction Escrow: Set up like other kinds of escrow accounts, construction escrow is focused on holding and disbursing borrowed construction loan proceeds to general contractors and subcontractors on building projects. Construction escrows are usually administered by title agencies, who, aside from paying vendors for their work, watch out for lien filings from unpaid vendors or other parties that could disrupt the project.  

Waiving an escrow account

Though escrow accounts are useful tools, they can have limited shelf lives. For instance, once your home equity reaches a certain threshold, you can ask your loan officer or servicer to waive the escrow requirement. Large mortgage down payments of 20% percent or more also may qualify you for a waiver.

Doing so, however, means you are solely responsible for paying in full and on time your property taxes, insurance, and other escrowed obligations. If you fail to keep up, your lender or servicer can revoke the escrow waiver. 

Now that you know the importance of escrow for buying and owning a home, let The Police Credit Union mortgage advisors share with you how our other home loan products and services can put you on a solid path to home ownership.