If you have ever shopped for a home or if you know someone who has, you have probably heard the term “escrow” used several times. But do you know what people are referring to when they use that term?
One of the simplest ways to understand the escrow process is this: If you and another person have ever made an informal wager, you may want an impartial third party to hold the money that was wagered for safe keeping. In many ways, this is how an escrow account works when you are getting a mortgage.
When buying a home, you are often required to put money into an escrow account. It is almost like a “good faith” account that shows you are serious about your intentions to buy the home. This money is held by a third party, or an escrow agent. This agent works for both you and the mortgage lender. The agent is responsible for carrying out any instructions that the mortgage lender and borrower require. For example, the mortgage lender may require the homebuyer to deposit money for the property taxes and home insurance. These can be monthly deposits that are then released once the transaction is completed.
In many cases, the escrow money is designed to protect the lender in the event of a foreclosure or repossession of the home. If the borrower does not pay their property taxes on time and a tax lien is put on the house, the lender could use the escrow money in a foreclosure to extinguish the lien and sell the house. Similarly, if the home were damaged or destroyed in some way, the lender would no longer have any collateral if the homeowner failed to pay the premiums on your homeowners’ insurance policy.
An escrow accounts also benefit the homebuyer. Instead of paying your insurance premiums and property taxes in one or two lump sums every year, escrowing the money can spread them out over 12 months (which can be a financial relief for people who are on a tight budget during the home buying process). In addition, escrow agents will request a title search for the home to ensure that it does not have any liens or other problems that could cost you more money and they will record the necessary documents on your behalf.
Escrow payments may change from time to time. Since insurance and taxes often change each year, the borrower may pay more or less on their monthly escrow payments for as long as the escrow account stays open. Lenders typically require up to two months of expenses in your escrow account and they will review your account to adjust your payments accordingly each year.
Before agreeing to put your money into an escrow account, you should understand all of the benefits and ramifications. It is difficult to cancel an escrow account so you should consult with a trusted financial advisor.
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