Demystifying Escrow For First-Time Home Buyers

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Demystifying Escrow
For First-Time Home Buyers

By June Fletcher

Question: Why is money put into escrow when you buy a home?

-- Myra Brown, Norfolk, Va.

Myra: Like "Is there a Santa Claus?" this question is deceptively simple and profound -- because in a world where we all knew and trusted each other, there would be no need for escrow.

Unfortunately, that's not the case. Most real-estate deals are conducted between strangers, and you don't know whether or not you're dealing with a Grinch. Hence the need for escrow, a word that can be either a noun or a verb, and which refers to the process of having money, deeds and other documents held by an impartial third party in a transaction until the principals perform as they agreed they would.

The term can be confusing to first-time home buyers, because both brokers and lenders use escrow for different reasons. When a seller accepts an offer on a house, the money that the buyer included in the bid is put into an escrow account, usually at the title company conducting the closing. At that point, the deal is said to be "in escrow." When the sale is finally complete and the escrow officer distributes all the money and ownership documents as specified in the purchase agreement, escrow is said to be "closed."

But that's not the end of escrow for many buyers. Lenders don't quite trust that their customers will pay taxes and insurance on the properties they've just purchased, and they want to protect their investments. So they insist on opening new escrow accounts -- sometimes called escrow impound accounts -- for any property purchase where the borrower has put less than 20% down. Typically, the lender will collect taxes and insurance pro-rated by month, along with a two-month cushion to guard against tax increases. The money that goes into the account earns interest, but unless state law specifies otherwise, the lender usually receives it.

Borrowers who put down more than 20% can choose to waive escrow, pay their taxes and insurance directly, and invest their funds elsewhere. But because lenders can't be sure you will pay these fees, they consider these loans to be riskier, and usually charge a waiver fee, often around a quarter of a point. On the other hand, if you put more than 20% down and still have the lender escrow the funds, you can often negotiate a lower interest rate.

Whenever your money is put into escrow, it's important to read supporting documents carefully, because mistakes and oversights do happen. For instance, the Real Estate Settlement Procedures Act requires that lenders send borrowers an annual statement showing current and projected payments, and any shortages, and that they return any excesses of $50 or more. I recently received such a statement for a property I own in Florida. The statement projected that I needed to escrow more than $100 a month for flood insurance next year, even though I have always paid for flood insurance through my monthly homeowners' association dues. (It fell to me to call the homeowner's association and have them fax a document proving the insurance had indeed been paid for the coming year.) 

For more information, consult Sandy Gadow's "The Complete Guide to Your Real Estate Closing" (McGraw-Hill, 2003) and Peter G. Miller's classic guide, "The Common-Sense Mortgage" (Contemporary Books, 1999).

-- June Fletcher is a staff reporter at The Wall Street Journal and the author of "House Poor" (Harper Collins, 2005). Her "House Talk" column appears most Fridays on RealEstateJournal.com. Email your questions about the residential real-estate market. Please include your name, city and state. If you don't want your name used in our column, please indicate that. Due to volume of mail received, we regret that we cannot answer every question.

Email your comments to rjeditor@dowjones.com.

-- December 16, 2005