What is an Escrow Account? - Definition & Rules

Instructor: Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

Escrow is used in real estate sales transactions and in the servicing of mortgage loans every day. In this lesson, you'll learn what escrow is, who's involved and how escrow accounts are used in real estate transactions.

Escrow Defined

Samuel is a first-time homebuyer who has been house-hunting for months, and he just placed an offer on a house. The following day, his agent, Bethany, calls him with great news. She tells Samuel that they can open escrow because the seller has accepted his offer. Samuel's ecstatic, but also confused. He asks his agent what exactly escrow is because he's heard the term being thrown around a lot regarding real estate deals.

Bethany explains that escrow is a way for money and property to be transferred from one party to another through the use of a neutral, third-party agent known as an escrow agent. The escrow agent holds the property until instructed to release the property to the other party once certain established conditions have been met. The terms and conditions between the parties in an escrow arrangement are outlined in an escrow agreement. Bethany also informs Samuel that he may have two different types of escrow arrangements relating to his purchase. Let's take a look at each.

Escrow During the Sale

Buying real estate involves swapping a big sum of money for a piece of dirt, often with a building on it, worth a big sum of money. Moreover, transferring real estate is a lot more complicated than handing over a check and taking the keys to the house. Escrow makes it a lot safer for both buyers and sellers to close the sale without worrying about getting cheated.

In our example, Samuel's seller will deposit a deed to the real estate into escrow, and Samuel will deposit his payment for the real estate into escrow. Once all the conditions for closing the sale have been met, the escrow agent will be authorized to release the deed to Samuel and the payment to the seller.

Escrow and Loan Servicing

Bethany also advises Samuel to discuss escrow with his lender. Oftentimes, a lender will require that borrowers make monthly payments into escrow along with their monthly loan payments. The monthly escrow payments are to cover the taxes and insurance on the real estate. In fact, a PITI payment is what we call a payment of principal, interest, taxes and insurance related to a real estate loan. The escrow agent will distribute the tax payments and insurance payments to the appropriate party when they become due.

Lenders like using escrow for taxes and insurance to protect the collateral on their loans (i.e., the real estate). The collateral isn't worth much if it burns to the ground and there's no insurance. Likewise, if Samuel fails to pay his property taxes, the real estate can be sold at a tax foreclosure sale.

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