Understanding The Mortgage Escrow Process

If you’re preparing to buy a home, chances are you’ll hear the word “escrow” at some point. Here is what to expect in the escrow process.

What is escrow and how does it work?

Escrow is technically a legal process in which a third party holds onto money in a designated account for a set time until a particular condition is met, such as the fulfillment of a purchase agreement.

There are three common types of escrow accounts. The first is one used for the purchase of a home.

“The purchase agreement usually includes a provision for the buyer to provide an earnest money deposit,” explains Tom Trott, branch manager for Embrace Home Loans in Frederick, Maryland.

The earnest money deposit — generally 1 percent to 2 percent of the home’s price — is held in an escrow account until the contract is finalized, after which the funds will go toward the buyer’s down payment or closing costs. If the agreement is voided, the deposit will go to either the buyer or seller, depending on what the contract stipulates.

The second type of escrow account is managed by your mortgage lender or servicer, and the funds you deposit are used to pay property taxes, homeowners insurance and mortgage insurance (if applicable).

A third type of escrow, if needed, involves anything unresolved in the real estate contract.

“For example, if the seller left furniture, did not complete repairs or if the property was damaged, the settlement company may hold back the seller’s funds in escrow until the contract is fulfilled,” says Trott. “Once fulfilled, the funds would go back to the seller or be used to pay for outstanding bills.”

Is escrow required?

When buying a home, putting money in an escrow account is required under certain circumstances.

“Conventional loan guidelines recommend escrow accounts for first-time homebuyers and borrowers with poor credit, but they don’t mandate these accounts unless you put down less than 20 percent,” says Chad Holsted, a mortgage loan originator with Atlanta-headquartered Silverton Mortgage.

Escrow accounts are also required for FHA loans, Holsted adds.

For VA loans, you are required to put down at least 10 percent to opt out of an escrow account.

Steps involved in the escrow process 

After lining up a mortgage and as you make an offer on a home, the escrow process involves several phases:

1. Opening an escrow account

The first step is to open an escrow account, which is usually done by the seller, but can also be done by the buyer.

“Your real estate agent will receive your earnest money, which will eventually be applied to your down payment and deposited into an escrow account held with a particular escrow company or service specified in your purchase agreement,” explains Lyle Solomon, principal attorney with Oak View Law Group in Rocklin, California. “Your agent will initiate this process once you and the seller agree on a price and sign a mutually acceptable purchase agreement.”

The escrow agent could be a title business specializing in real estate, a bank or other financial firm, or it could be a private third-party entrusted with the task. Alternatively, an attorney can manage this process, in which case it might be referred to as “settlement” instead of “escrow.”

2. Appraisal and home inspection 

Your mortgage lender will order an appraisal of the home. If the appraised value of the home is less than the proposed purchase price, your lender will not grant you the funds for your mortgage unless you’re willing to pay the difference in cash or the seller agrees to lower the price to the appraised value.

As the buyer, you have the option to (and should) hire a home inspector to carefully evaluate the condition of the home and its habitability.

“Your home inspector will look closely at the structural integrity, electrical and plumbing, kitchen, bathrooms, windows, roofing and heating system and render a report to you, which will detail any outstanding conditions that need to be addressed and any repairs or upgrades that are recommended to be made,” explains James Orlando, vice president of Brooklyn MLS in New York.

You’ll also want to review disclosures from the seller. The seller is obligated to report known negative conditions or flaws that presently exist with the home.

“You should receive a written seller disclosure statement that indicates any evident faults and review it carefully with your agent,” says Solomon.

3. Obtaining insurance coverage 

Your mortgage lender will require you to obtain homeowners insurance for the property, and to pay for title insurance. Unless you get an additional owner’s policy, title insurance primarily protects the lender from any legal challenges that could surface from defects with the home’s title, or ownership.

4. Final walkthrough

Assuming all goes well with the appraisal and inspection — and nothing changes in your financial situation that could derail your mortgage approval — you’ll have an opportunity to visit the home just prior to closing for a final walkthrough. This helps ensure there’s no new damage to the home and that the seller has fulfilled the terms of the purchase contract, such as leaving behind appliances or fixtures they agreed on.

“You generally won’t be allowed to back out at this stage unless the house has been seriously damaged,” says Solomon.

5. Closing

At least three business days prior to closing the transaction, you’ll receive a closing disclosure document from your lender with a finalized list of closing costs, including escrow amounts, Orlando says. Compare this to your loan estimate (which you received when you applied for the loan) to ensure there aren’t any material changes to the costs.

“These two documents have a lot in common,” says Solomon. “Look for any unneeded, unexpected or excessive expenses as well as any errors.” 

When it’s time to close, the escrow agent will create a document naming you as the homeowner and file it with the local records office, then wire the funds to your escrow account so the seller and seller’s lender can be paid, says Solomon. For the remaining down payment and closing costs, you’ll need a cashier’s check.

6. Paying insurance and taxes

After you buy your home, a different kind of escrow account is managed by your mortgage lender or servicer, with the funds in this account going toward property taxes, homeowners insurance and (if you’re required to have it) mortgage insurance.

Your lender will divide these yearly amounts by 12 and add them to your monthly mortgage payment. When these bills are due, they’ll be paid on your behalf automatically from your escrow account balance.

“You’ll receive an annual escrow account statement once a year that itemizes the payments into and out of your escrow account,” adds Holsted. “You’ll also be notified of any shortfalls you owe or refunds due within 30 days of preparing the statement.”

You might be able to terminate a mortgage escrow account eventually, although the restrictions for doing so vary from lender to lender. If this is an option, you’ll need to be in good standing with your payments, says Solomon.

However, maintaining an escrow account can lend peace of mind — it ensures your bills are paid on time, and you won’t have to keep track of them, Holsted says.

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