What Is Escrow? - Definition & Process

Instructor: Jay Wagner

Jay holds a Masters of Business Administration

Escrow is, in some ways, like an insurance policy. It depends on a third party to ensure that the terms of an agreement are met and that money (or other assets) only changes hands when those terms are met. If you think escrow is only for real estate purchases, you may be in for a surprise!

What is Escrow?

In its basic form, escrow is an arrangement between three parties where one party receives money or other assets and then disburses them, either between the other two parties or to outside parties, on the basis of some predetermined conditions. Within this framework, escrow can take on numerous forms, and we'll briefly go over ten of the most common of these.

Escrow in a Vending Machine???

The first form of escrow that we'll discuss is what we might call mechanical exchange escrow. You don't see it and may not realize it, but you enter into an escrow in this form every time you use a vending machine.

Let's say that you're an insatiable Dr. Pepper drinker. You work near a machine that vends 12-ounce cans of your favorite soft drink for a mere 50 cents each, and you visit this machine several times each day. Each time, you put two quarters into the machine and press the button for Dr. Pepper. You may have noticed that when the can vends, you actually hear two noises: the can dropping into the bin for you to pull out and your coins dropping into the coin vault of the machine. The coins didn't drop immediately because the machine held them in escrow until (1) you made your selection and (2) the machine verified that your selection could be and was delivered (unless it got caught in the chute, but that's another matter). Voila, you have participated in a mechanical exchange escrow where you and the owner of the machine are the participants and the machine acts as escrow agent!

Escrow at the ATM

When you withdraw funds from an ATM, no escrow is involved: you swipe your card and punch in or select the withdrawal amount, and the machine instantly makes sure the transaction is authorized and then dispenses the money.

But what about when you make a deposit into your account using the ATM? In this case, the ATM doesn't just swallow your money, nor does it generally credit your account with the deposit. Instead, the ATM puts your deposit in its escrow vault, where it is held until it can be retrieved and credited to your account by humans.

Some ATMs can count and credit certain deposits. These machines also hold the money in escrow until you okay the count. If for any reason you disagree with the count, the machine will give back the money you inserted and you can try again, drop it in the night deposit, or wait until the bank is open and you can deal with a person.

Internet Escrow

If you buy or sell on online auction sites such as eBay or uBid, you may have been involved in Internet escrow at one time or another. While Internet escrow is rarely, if ever, used in transactions that are confined to the United States and Canada, it is frequently used in international transactions.

In Internet escrow, the escrow agent is usually also the money exchange agent (PayPal, for example). The difference between an Internet escrow sale and a normal online auction sale is that when the buyer pays the money to the money exchange agent, it isn't immediately added to the seller's account. Instead, they hold it in escrow until they receive confirmation that the seller has shipped the item, and then release the money to the seller's account.

Intellectual Property Escrow

Not all forms of escrow involve money, but they all involve something of value. Intellectual property escrow is one of the non-monetary forms of escrow. It is most frequently used in computer programming.

Most computer applications are not written by one programmer, but rather by a group of programmers who may not even be in the same location or work for the same company. While they license their portion of the programming to the application publisher, they retain all rights to it until all of the programmers have submitted their portions and the application has been compiled, tested, debugged, and is ready for the market. Between the time that they submit their portion of the programming and the time when the conditions of the license they granted to the publisher are met, their code is held by a third party in source code escrow and remains the property of the programmer. If all portions of the program are received by the escrow agent, they are released to the publisher so the application can be completed and marketed.

Warranty Escrow

Let's say you find a used car that you would like to buy, and the seller offers a 90-day money back warranty on the car. The problem is, you don't know the seller and the seller doesn't know you, so you aren't willing to pay until the warranty expires and the seller isn't willing to let you have the car for 90 days and then hope you come back to pay for it.

The solution is warranty escrow. In this form of escrow, a third party (a bank or a lawyer, for example) holds the money until the warranty expires and then delivers it to the seller. If the car breaks down before the warranty expires, the escrow agent verifies that you delivered the car (now a lawn ornament) to the seller and then refunds your money to you.

Legal Escrow

While legal escrow can be used in bankruptcies and structured settlements of lawsuits, it is most often used to receive and disburse settlement funds from class action lawsuits. You may have seen advertisements about class action suits against companies that manufactured various products that were later deemed unsatisfactory or even dangerous. Most such suits are settled out of court, with the manufacturer paying millions or even billions of dollars into an escrow account, with the escrow agent tasked with verifying and paying claims under the terms of the settlement. The lawyers running these ads are not the escrow agents, but they are offering to represent claimants before the escrow agent and attempt to get the claimants a share of the settlement money (less a share that goes to the lawyer).

Escrow, Your Landlord, and You

If you rent a home or apartment, you undoubtedly paid a deposit when you signed your lease. You were promised that if you left the property clean and in good shape when you moved out, your deposit would be returned to you.

In a perfect world, your landlord would have placed your deposit with an escrow agent: for example, in an escrow account at his bank. It would stay there until you move out and, if the escrow agent judged that you had met the requirements to get it back, it would be refunded to you (otherwise it would go to your landlord for cleaning and repairs to the property).

In reality, very few property owners or managers go to this much trouble. Instead they simply account for deposits as a separate component of cash and basically borrow your money interest free.

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