What is an Escrow Account?



Escrow-based payments have been around for years and are not new. However, they have mostly been restricted to large transactions, like mergers and acquisitions, cross-border deals, etc. Industry experts say, with new technology and the rise of the internet-based economy, this instrument is increasingly being used by stakeholders from several sectors to have safe and secure transactions.

Understanding the concept of escrow can help one minimize risk and make transactions more secure and comfortable. It’s worth learning what escrow means and how it works whether you are dealing with a real estate transaction or an online sale.

What Is Escrow?

Escrow is a financial arrangement in which two parties bring onboard a third party (who is neither the buyer nor the seller) to temporarily hold money, paperwork, security or other assets for a transaction on their behalf before the transaction has been finalized.

Ideally, the third party, known as escrow provider is neutral to whichever direction the transaction goes into. It isn't concerned with whether the buyer or seller comes out ahead or the transaction happens or fails (although they might prefer to see the deal go through, then they'll get commission as well ^_^).

Its job is to make the transaction safer by protecting the assets of the buyer and seller until both parties have met their obligations for the agreement.

What is an Escrow Account?

An escrow account is an account designed to hold funds or other assets temporarily in safekeeping. It is a third party account where funds are kept before they are transferred to the ultimate party. It provides security against scams and frauds especially with high asset value and dispute-prone sectors like Real Estate.

How escrow works?


When you commit to buying or selling something, you need to fulfill certain terms. For example, the buyer must pay the mutually agreed cost/amount by a specific time, and the seller must provide the asset in exchange. Though most transactions involving escrow are more complicated than that. For example:

Buyers might want to inspect the property or goods they are buying before paying.
Sellers might want some surity that they'll get paid (or even have the flexibility to inform and move on in case they will not be able to fulfil the task ).
The item being sold might be a service instead of a product, for which fixing a price is much more difficult.

In complicated arrangements like these, one party may feel unsure that the other will meet their end of the bargain, leading to a third party being roped in to act as a "referee." The escrow provider acts as a middleman and ensures that the buyer and seller abide the agreement.

Uses

Escrow can be used in any number of financial and legal scenarios where something of value exchanges hands from one party to another. Majorly it applies to real estate and online transactions.

1) Real Estate Transactions


Escrow account is widely used in the real estate transactions. In fact, most people get their first exposure to escrow when buying or selling property. Escrow opens when a signed agreement is delivered to an escrow officer, who ensures that the conditions of the contract are all satisfactory. The officer may verify the address of the property, location, check disclosures, and make sure any objections are resolved before the transaction goes through.

An earnest money deposit is probably the first time you’ll notice escrow in a home sale. The buyer writes a cheque payable to the escrow holder, who will either refund the money if the transaction breaks down, pay it to the seller for completion of transaction, or pass it on to the seller as forfeited funds if the buyer fails to meet the requirements of the contract.

Escrow closes when the purchase money is disbursed to the seller and the asset is recorded in the name of the buyer.

If the cheque was paid directly to the seller, it would mean taking significant risk for the buyer. Not much could be done to stop a 'dishonest' seller from cheating in such a case.

2) Online or Overseas Transactions


Online sales are particularly risky as you’re dealing with somebody you don’t know anything about, and they might be many miles away. So doing due dilligence might not be easy and taking legal or punitive action if something went wrong might not be worthwhile either.
  • As a buyer dealing with a dishonest seller, you may not get the goods you purchased.
  • Online scammers routinely take advantage of sellers, by hacking their card number using fake transactions.
  • It’s not even practical to always demand that buyers easily make upfront payment -especially for expensive items.

There are a few ways to make online transactions safe:
  • Trading in marketplaces where buyers and sellers have a reputation can improve the odds of completing a safe, successful transaction.
  • If you’re using your credit/debit card’s keep the consumer protection features handy.
  • Another less known approach (which we are going to talk about specifically) is to have an escrow service handle the transaction.

During an online sale, a buyer and seller might agree on several terms:
  • How much the buyer must pay and mode of payment.
  • How and when the seller will ship the goods.
  • Duration for buyer is allowed to use and inspect the goods and return if dissatisfied with the quality.

If an escrow service is added to the equation, the buyer and seller just need to fulfil their parts of the transaction.
  • Suppose seller never ships anything, the buyer gets his/her money back from the escrow provider.
  • If the buyer says the goods never arrived (some people use this trick to get things for free), the seller and escrow company review the situation. If the buyer agreed to complete the transaction based on those confirmations and there’s proof of shipment, the seller get the payment.

Some other situations where escrow accounts are useful:

1) Monthly Payments

When you borrow money to buy a home, using an escrow account for monthly payments might be a good idea. Expenses like homeowners insurance and property taxes are often annual expenses, but the thought process of people is generally in terms of monthly payments. So large annual bills catch them by surprise.


To break those payments down into manageable pieces, lenders often suggest and even add it to the clause to save a portion of the annual amount each month. With each monthly payment, your funds go toward your loan balance (principal and interest) as well as your taxes and insurance. Those payments are often called PITI payments. This way each month, the amount for your taxes and insurance goes into an escrow account until annual bills come due.

Here are a few considerations for escrow:

Is such a procedure mandatory or optional?

Some lenders require that you use an escrow account. Even when they don’t, spreading out the payments means one won't have to scramble for funds when a semi-annual or annual bill reaches your doorstep.

Lenders appreciate use of escrow accounts because failing to pay taxes and insurance bills puts them at risk. They just want their money back safely, and if say taxing authorities blacklist your home, it becomes harder for you and the lender to sell.

Money laying idle without any interest, etc?

This is a valid point that maybe one can earn more on your savings if kept in a high-yield savings account. But think for moment - how much would you keep in your escrow account at any given time? Especially when interest rates are low, any extra earnings you might get at the bank of your choice won’t amount to much. Is it enough to remove the wings of caution?


2) For Renters and Landlords


When it comes to renters, escrow may be useful in two ways:

i) Security Deposits

In some states, landlords must keep a certain sum of the payment received as security deposits in an interest-bearing escrow account. It provides safety to renters that they will get their money back and that funds are also available to make repairs if needed. If landlords just deposit funds in an operating account, it’s easy to lose track of the money and spend it on other needs.

ii) In case of disputes

If landlords fail to address renter needs (like the need for running water or heat), renters might be allowed to withhold rent payments. But (depends on regulations in an area) renters might be required to deposit the regular rent payment into an escrow account. Doing so protects the landlord and shows that the renters aren't flinching away from making payment, they just want the services they’re paying for.

Stay Inquisitive 💡

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