The term “escrow” can confuse first-time homebuyers because it has a few different meanings. Escrow is a vital part of any real estate transaction because it’s considered the glue that holds it together.
When purchasing a home, it’s essential to understand the ins and outs of escrow funds. Let’s take a comprehensive look at what you need to know about escrow in real estate.
What is exactly is escrow?
For purposes of a real estate transaction, escrow is monies that are held in what’s called an escrow account. Often, these funds are referred to as “earnest money.” In other words, by putting monies into an escrow account, the buyer shows the seller that they are earnest about buying the property.
If a buyer does not follow the contract they have agreed to with the seller, their earnest money deposit could become at risk. The escrow monies hold a buyer’s feet to the fire, so to speak, to ensure they follow through with the purchase.
How much escrow is typical in a real estate transaction?
The amount of money held in escrow can vary based upon where you’re located. In some areas of the country, escrow funds are relatively standardized. You can expect in most places, the amount of funds held in escrow will be somewhere between 1-5% of the purchase price.
If you happen to be constructing a new home with a builder, it’s possible you could see the escrow reach as much as 10% of the house purchase. There is more risk for the builder when custom building a home—hence the more substantial escrow deposit.
Who holds the escrow funds?
Who will hold the escrow funds also varies by location. The listing real estate broker holds the funds in an escrow account in some parts of the country. In other areas, a third party will hold the escrow monies. There are “escrow companies” whose job is to maintain and account for funds until closing.
It’s also possible a real estate attorney could hold the escrow.
When does an escrow account get opened?
Typically, the listing real estate broker will open an escrow account once the buyer and seller have executed an offer to purchase agreement. The escrow monies will go into an account and be duly accounted for until closing.
When a third party holds escrow, it will also be established once a contract has been ratified.
What happens when there is an escrow dispute?
Every now and then, a real estate transaction will go sour. The buyer and seller will have agreed to the contract terms, but one party ends up violating those terms. In such instances, it’s possible a deposit dispute could arise.
For example, in most real estate contracts, they will have a mortgage contingency when a buyer is procuring financing. The mortgage contingency clause will state that the buyer will be getting funding for X dollars by a specific date.
If the buyer is not going to get financing by the date in the contract, they must notify the seller in writing before the expiration of such date. If the buyer does not ask for an extension, then the mortgage contingency clause is no longer in effect.
Over the years, many home buyers have mistakenly not notified the seller in writing of the need for a financing extension. When this happens, they leave themselves vulnerable. Sellers in this circumstance would be able to keep the buyer’s escrow deposit.
If a buyer disputes this legality, the escrow agent must hold the funds until a court of competent jurisdiction decides who gets to keep the money. Escrow agents cannot unilaterally determine who should get the funds. Even if one party clearly deserves it.
Final thoughts
Without having escrow, a buyer would have no “skin in the game.” They would be free to walk from a transaction on a whim. The need for having escrow funds is substantial. Hopefully, you now have a much better understanding of how escrow works in real estate.