Whether you’re selling or purchasing a home, escrow is an important financial term that you’ll certainly come across in your home buying or selling journey. Escrow is a financial arrangement where an impartial third party agrees to hold a certain amount of funds until the transaction between the other two parties has been finalized. This financial arrangement can take place in all kinds of different transactions but is almost always present in the buying or selling of a home.
During the sale of the home in question, the prospective buyer will place a certain amount of money into an escrow account, which is held there until the sale is finalized and agreed terms are met. The primary purpose of escrow is to minimize the potential of fraud for larger financial transactions. This process is necessary within the real estate industry because of how much money is involved with the transaction between the buyer and seller. Since the home will need to be taken off the market during the closing process, escrow acts as a sign of good faith to the seller.
Using escrow provides the real estate transaction with an added level of security, which is beneficial to both parties. Sellers can be more confident that the prospective buyer is actually interested in going through with the purchase. Since the escrow payments remain in an escrow account, the seller won’t receive the money until the sale has been finalized, which protects the buyer from issues where the check is cashed immediately and finalization of the sale becomes difficult.
If you’re interested in purchasing or selling a home, understanding how escrow works should help you avoid any unexpected surprises during the sale of the home.
How Escrow Works
When you’ve found a home that you’re interested in and are thinking about making an offer, you’ll be required to place an earnest money deposit into an escrow account. The total amount that you will be required to pay for your earnest money deposit typically ranges from 1-3 percent of the price of the home. The exact rate that’s chosen depends on a variety of factors such as the current market performance. If the housing market that you’re purchasing a home in is highly competitive, you may be required to place as much as 5-10 percent of the price of the home into escrow. This deposit shows the seller that you’re serious about purchasing the home. The deposit that you’ve made will remain in escrow until the closing process has been completed and the sale of the home is finalized.
Once the closing process has finalized, the funds within escrow will typically be applied to the down payment that the buyer made as well as the closing costs. If the buyer withdraws their offer because they are no longer interested in the home or for reasons that weren’t listed in the initial contract, the seller will keep the money that’s tied to the escrow account.
The earnest money deposit that you make will be held by an escrow agent. This agent can be anyone from an attorney to a representative of the main title company for the home in question. This individual must be a third party who’s impartial and in no way represents the seller or buyer.
If you’re selling your home without the assistance of a real estate agent, you’ll likely be required to hire a third party individual to perform this task. This loan officer will also be in charge of certain loan documents until the sale has been completed. Once the sale of the home is finalized, the escrow officer will provide the funds from escrow to the appropriate party. They will also file any necessary paperwork tied to the escrow account. If the transaction was completed successfully, the escrow funds should be transferred to the seller.
What Does Escrow Balance Mean?
While escrow in real estate mainly refers to the earnest money deposit that remains in escrow while the sale of the home is going through its final stages, keep in mind that escrow accounts apply to buyers even after the purchase has gone through. You will have an escrow balance that will be used to pay home insurance payments and property taxes on an annual basis. This escrow balance refers to money that’s set aside for a third party to pay when your insurance premiums and property taxes are owed each year.
The monthly payments that you make to your escrow balance are based on the estimated annual costs of your insurance premiums and property taxes. A lender will automatically take two months worth of these payments when the sale of the home is finalized. After this period, the escrow balance that you owe will be positioned as a line item on your monthly mortgage bill. Every time you make these payments, the money will sit within your escrow account and will be held by a third party until the end of the year when the proper tax agencies and insurance companies are paid.
What Are the Fees/Closing Costs and Who Pays Them (in Arizona)?
Once an offer has been made on a home, the final closing process will begin, which is when inspections are typically performed and loan approval occurs. While the overarching process seems simple and straightforward at first glance, there are a myriad of fees and closing costs that you will be required to pay if you want the sale of the home to go forward.
A couple of inspections will need to take place before the house has been closed on, which include a standard home inspection for $250-$500 and a termite inspections for $50-$100. Once these inspections have taken place and the buyer has signaled that they wish to move forward, a final appraisal of the home will occur to make sure that the value of the home matches the price of the home. Appraisals typically cost anywhere from $300-$500.
In the state of Arizona, the buyer is usually required to pay notary fees, prep fees for documentation, half of the main escrow fee, the title policy, the HOA transfer fee, any accumulated interest on the new mortgage, the home warranty, and the the homeowner’s insurance policy premium for the initial year. These fees usually add up to around $2,000-$3,500. The seller must also pay half of the escrow fee, which usually amounts to $300-$600. Some of the other fees that a seller may be required to pay include the payoff of any liens or mortgages remaining on the home, any remaining property taxes, HOA delinquencies, the home warranty, HOA transfer fees, possible loan fees, the owner’s title insurance policy, and commission to any real estate agents who assisted in the sale of the home. Aside from the commission that you will need to pay to real estate agents, the other closing costs that you’ll encounter when selling a home will likely amount to $2,000-$4,000. Keep in mind that these numbers are just rough estimates based on industry averages.
Escrow Officer vs. Escrow Agent
Escrow officers and escrow agents are typically used interchangeably despite the fact that there are some key differences between the two roles. An escrow officer is usually a member of the title company who will issue any necessary title insurance policies while the closing process is ongoing. It’s also possible for an officer to act as the third-party for the escrow account. In fact, most title companies have their own escrow offices that their officers operate out of.
Escrow agent is a term that’s used more specifically for the individual who is in charge of the escrow account. This individual will need to be an unbiased third-party. While the main responsibility of the escrow agent is to keep track of the funds and assets that were placed in escrow, they will also attend numerous matters pertaining to the opening, maintaining, and eventual closing of a real estate transaction. Along with title company officers, notaries and attorneys can also be escrow agents. The agent has a responsibility to both the seller and buyer of the home.
What Is an Escrow Shortage?
Now that you understand the basic of escrow and how it can apply to you as a buyer or seller, you should also have a firm understanding about escrow shortages. An escrow shortage is something that could apply to buyers once they’ve purchased a home. The escrow balance that you’ll maintain after you’ve purchased a home refers to the money that you owe each month for your taxes and insurance premiums. When you make these payments, the money goes into your escrow account and is held there until the end of the year. While this is a simple process, it’s possible for an escrow shortage to affect the process.
As mentioned previously, the monthly payments that you make each year are based on estimates of what your insurance premiums and property taxes are going to be. These estimates aren’t always accurate and can either be overestimated or underestimated, an escrow shortage is when the funds you initially placed into the escrow account are not enough to cover the final calculated costs of the home including taxes and fees. The most common reason for an escrow shortage is for property taxes to increase.
Let’s say that you’ve been told that your property taxes will amount to $2,000 for the year with your insurance premiums amounting to $1,500. As such, you would pay just over $166 for property taxes each month and $125 for your homeowner’s insurance. At the end of the year, an escrow analysis will take place to identify how much you should actually owe. Your property taxes could rise to $2,400 and your homeowner’s insurance to $1,800, which means that you would owe money to make up the difference. While it’s impossible to avoid these shortage problems, you could place more money into a separate savings accounts in order to prepare for such a possibility. You should also pay attention to any tax changes in your city, notifications of which should be mailed to you by your insurance company.
What Is an Escrow Service?
An escrow service refers to any company that offers services for handling the escrow process and transactions pertaining to this process. For a small fee, the escrow service provider will collect, hold, and disburse the funds involved with escrow. While escrow services are perfectly viable solutions for any large transaction between two parties, the real estate industry escrow is handled between parties as opposed to using a service. The third party individual simply needs to be someone who is completely impartial. Outside of real estate, escrow services are commonly used for large online transactions for additional security.
We hope this guide has helped you better understand the process of escrow and the many benefits it has in the real estate process. If you’re looking to buy or sell a luxury home in Tucson, please feel free to get in touch and we’ll be more than happy to answer any questions you may have!