When you’re involved in a large transaction, either as a buyer, or seller, it can be a risky deal.
Escrow is a way you can reduce your risk when dealing with a transaction involving a large sum of money.
Whether escrow is being used to help facilitate real estate sales or an online transaction, you need to know what they are and how they work.
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What is Escrow?
The official definition is a deed, bond, money, or other documents kept in the control of a third-party, taking effect only when a specified condition has been fulfilled.
Escrow is when you use a third-party to hold onto something until all the transaction details are complete, and both the buyer and seller are satisfied with the deal.
An escrow service provider is a party that has no interest in the transaction and remains neutral if there is a contract involved, as typically is the case.
The escrow service waits to ensure both parties fulfill all of the contract terms before the escrow deposit is released.
How Escrow Works Infographic
Escrow should be used in transactions involving the sale of something of value. Typically, escrow is seen in real estate purchases and large online purchases.
How Escrow Works in 7 Steps
1. Buyer and Seller agree to terms – When a buyer agrees to purchase an item from the seller, they enter into an escrow agreement allowing a third-party to hold the funds until all details and conditions of the agreement are finalized.
2. Buyer pays Escrow- The escrow account will be set up for the buyer to deposits money to be held. Once the escrow money plus fees are received, the seller is notified. A cashier’s check, bank account wire, or even PayPal can be used with some escrow services.
3. Escrow Fees – The escrow holder will require a fee that is usually split between the buyer and seller
4. Seller sends the item to Buyer – After being notified that the payment is in escrow, the seller ships the items to the buyer. A tracking number is supplied, so the escrow service provider can verify the item has been shipped, and the buyer receives it.
5. Buyer receives item/s – The buyer’s amount of time to inspect the item will be outlined in the escrow agreement.
6. Buyer accepts item – Buyer approves of the merchandise.
7. Escrow funds released – When the buyer informs the escrow agent, they are satisfied with the item. The money will be released to the seller, minus any escrow fees.
Example of the Escrow Process
Let’s say you find a rare piece of artwork online and want to purchase it. The artwork is fairly expensive, valued at $5,000.
You don’t want to send $5,000 to a strange company hoping what you get is authentic, you use a third-party escrow service.
You have an agreement with the seller that you want the artwork authenticated by a local appraiser before payment is released.
You will send the $5,000 escrow payment, plus any fees to the escrow company. They notify the seller they have the funds on hold, and the seller ships the item.
Once you receive it, you have so many days to get it authenticated. Once the piece is confirmed to be authentic, you notify the escrow service, and they release the funds to the seller.
Escrow in Real Estate Transactions
When you buy a home, there is almost always escrow involved. Earnest money is a percentage of the agreed-upon purchase price a buyer gives to a seller as a show of good faith that they will hold up to their end of the contract.
Earnest money is usually made out to the escrow agent and placed into an escrow account.
The purchase contract will outline the amount of earnest money required and terms and conditions that need to be satisfied to apply the funds towards the purchase price of the home.
In the agreement, certain conditions in which the buyer is entitled to have their earnest money refunded.
On closing day, you will meet with an escrow officer at the title company. The closing of escrow is when the final paperwork is completed, and escrow funds are released.
Escrow in Online Transactions
Escrow is not just for home purchases. They are routinely used in online transactions involving expensive items, such as art, collectibles, and memorabilia.
Such items are very risky for purchasing online from a company you do not know. People often sell fake items and try to pass them off as legitimate all the time.
Like in a real estate contract, the money goes to a third party to hold in escrow until the item is received and the buyer is satisfied. At which time the money is released to the seller.
Some escrow companies, such as escrow.com, are now able to accept escrow deposits using PayPal. Making it a much more convenient way to pay while still receiving the protection of an escrow service.
The Real Estate Settlement Procedures Act, RESPA, regulates escrow accounts. Escrow is not something that is required by law but is usually automatically added to your loan.
RESPA does limit how much lenders can hold in escrow. They cannot hold more than 1/6th of the amount paid during a calendar year.
The only thing that the escrow account can be used is property taxes and the homeowner’s insurance policy.
What About Disagreements
Not every transaction involving escrow services goes through smoothly. In the event of disagreements, who decides?
Well, the escrow company will decide. Whether this a large escrow company, escrow officer, an attorney acting as an escrow agent, or a title company, they will use the terms outlined in the agreement to decide who is at fault and whether or not to complete the sale.
If the seller never sends the item, or it turns out to be not described, the buyer gets their money back.
If the item is delivered and the seller meets all of the sale’s terms and conditions, the money is released to the seller.
What is a Mortgage Escrow Account
When you get a mortgage, the lender will set up an escrow account for you. This is to pay the property taxes, mortgage insurance (PMI), and homeowner’s insurance premiums.
The lender calculates the costs of both and divides it up into 12 monthly payments.
The actual amount of your property tax may be different than your mortgage lender estimated.
In which case, the amount you pay into your mortgage escrow account is adjusted, changing your monthly payment.
Escrow in Stock Market
When a public company gives shares of its stock to an employee, the funds are often held in escrow. The owner of the shares is not able to sell their stock while in escrow.
Escrow shares are common when a company is in the process of a merger or acquisition or when shares of a stock are given to an employee.
Money is put into holding for the seller to make repairs within a certain time frame. If there are repairs the seller has promised to make, an escrow holdback is a way of ensuring the repairs are done and on time.
The purchase price determines the escrow fee. Many companies charge per side, with both the buyer and seller paying half of the fee. Paying $2 for every $1,000 plus a $200 fee.
For example, on a $250,000 home, the fee will be $250 plus $100 per side for a total of $350 each, or $700 total. Escrow fees will depend on the escrow company used.
The time frame that a third-parts holds the down payment and earnest money deposit until all terms of the real estate agreement are met is known as the escrow period.
There are usually several contingencies in a purchase agreement that need to be met to finalize the deal. The most common contingencies in real estate transactions are a home inspection, loan financing contingency, appraisal contingency, and title issues.
If any contingency is not met. For instance, the buyer cannot get approved for a loan; the buyer can get their money in escrow returned.
Home purchase agreements can get quite complicated; we advise that you always work with an experienced real estate agent to help you throughout the home buying process.