What is Escrow?
An escrow is a financial instrument held by an unbiased third party to protect the other two parties in a financial transaction. The funds are held by the escrow service until it receives written or oral instructions that both parties’ obligations have been fulfilled.
What are Escrow Services?
In a nutshell, escrow is a security service. Escrow services provide security in the handling and transaction of important property, funds and documents. Escrow personnel work closely with the buyers, sellers, lenders and borrowers involved in a transaction to ensure all funds and documents change hands at the appropriate time when certain preset conditions are met.
How Does an Escrow Account Work?
An escrow account is set up to collect payments over a 12-month period to be paid on your behalf. These payments go toward your property taxes, home owner’s insurance and possibly other items. You may be wondering why you can’t just pay these bills on your own, and you can as long as your lender is on board.
However, the lender makes the final decision. As investors, most lenders usually want to protect their investments and make absolutely sure that the property taxes and insurance are paid-to-date requiring an escrow service. This makes sense when you consider that unpaid property taxes result in a lien against the property and that lien supersedes the lender’s. No insurance also leaves the property (and their investment) uncovered and unprotected to damage such as a fire.
Why Escrow Taxes and Insurance Fees?
Aside from lenders protecting their investments, using escrow services to collect and pay your taxes and insurance can make life more simple for you. Let’s be honest, it takes some discipline and dedication to remember to set aside money every money on your own to ensure that there is enough to pay the bills at the end of the year when they are due. Often times, it is too easy to dip into those funds for other or unexpected bills. Think of an escrow account as an assurance that your taxes and insurance will be paid on time avoiding those pesky penalty and late fees.
How is the Amount in Escrow Determined?
Rest assured that if your lender requires an escrow account, the law limits the amount that you (the borrower) must pay. Usually, the lender divides the cost of your anticipated property tax, home owner’s insurance and any additional required items like owner’s association dues or flood insurance by 12. Then they collect that amount plus your payment (principal and interest).
As an example, let’s assume that you your estimated annual property tax bill is $1,500 and your annual insurance is $600. The lender will add $1,500 and $600 to get $2,100. Then they will divide the $2,100 by 12 to get your monthly escrow payment of $175.
What Happens When You Have a Shortage or Surplus?
Don’t fret about having a shortage. Your lender will likely offer you different options to make up the difference. Usually, you can choose to pay the shortage in full or space it out in 12 equal payments over the next year. You can even opt for a combination of paying some upfront and the rest over the next 12 months.
When the lender happens to collect too much over the previous year your escrow will have a surplus resulting in one of two options. For the first option, the lender could write you a check for the difference. For the second option, the lender could apply the surplus to the following year’s escrow payments. Most opt for option two as next year’s escrow could result in a shortage due to higher insurance premiums or tax increases.
When Does the Escrow Close?
After the buyer and seller have signed all the necessary paperwork and required funds have come in, the closing agent (escrow officer) then disperses the funds. They also oversee the recording of the documents with the county.
When the deed is filed, the title to the property is officially transferred to the new owner and the transaction is complete. The escrow is now closed.
Both parties will receive a final closing statement and all other documents outlining all aspects of the financial transaction. Make sure to look over these documents carefully and notify the closing agent of any errors. Keeping the documents will help with filing your taxes.