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What is Escrow?

Updated: Feb 4, 2022

First-time home buyers often ask: ”What is escrow?" We’ll explain not only what is escrow but how it works.

Definition of Escrow

Rocket Mortgage defines “escrow” as “a legal arrangement where a third party temporarily holds large sums of money until a real property purchase agreement terms are met”. It protects both the buyer and the seller during the home buying process.

What is Escrow?

How the Escrow Process Works

9 steps during the escrow process:

  1. Opening an Escrow Account;

  2. Earnest Money Deposit;

  3. Apply for Financing;

  4. Lender’s Approval;

  5. Home Inspection;

  6. Title Report and Insurance;

  7. Final Walk-Through;

  8. Reviewing the HUD-1 Form; and

  9. Escrow Closes.

Opening an Escrow Account

After the buyer and seller agree on a purchase price and the conditions for completing the sale, they sign a purchase and sale agreement, a legally binding contract.

For the protection of both parties an outside party (acting as a neutral third party) holds the money in a separate “escrow account” in a bank (or financial institution). The conditions and terms of the agreement tell the escrow officer how the funds are distributed and when the buyer takes title to the property.

The escrow account closes when the title passes from the seller to the buyer and all funds are disbursed.

Earnest Money

Once the buyer and seller sign a purchase and sale agreement the real estate agent collects the buyer’s earnest money (a good faith deposit). Then, deposits it with a transaction closer (title insurance company, escrow company, or an attorney) as an initial down payment.

The earnest money deposit (EMD) shows the seller that the buyer is serious about buying and the EMD is proof of good faith. If the buyer fails to complete the sale without a legal reason, the seller can keep the EMD and is free to sell the house again.

To protect the buyer, the EMD is not given to the seller who can cash it and later refuse to complete the sale. Instead, the EMD gets deposited with a closing company that holds it in escrow until the title passes to the buyer or the sale cancels.

Tip: Read our blog post explaining “What is the EMD (Earnest Money Deposit Check)?” which explains the EMD in greater detail.

Apply for Financing

Tip: Before making offers on homes, you should go to a lender to get a “pre-approved“ letter stating how much of a loan (mortgage) you qualify for. This lets sellers know that you can obtain the funds to complete the purchase. Thus, the seller saves time and money by selling to a buyer with a pre-approved letter.

Bonus Tip: Read our blog post “Is It Hard To Get Pre-Approved For A Mortgage?” which gives you more information about pre-approved letters.

After you give the lender the property’s address it will prepare a “good faith estimate” statement detailing the loan amount, interest rate, and closing costs to complete your purchase. Remember, this is only an estimate depending on the property appraisal and other costs associated with the “contingencies” in your purchase agreement.

Tip: Read our blog post explaining “What are Real Estate Contingencies in California?” to learn more about how to use them to your advantage.

Lender’s Approval

Unless the purchase is with “all cash” the buyer needs to get a loan (home mortgage) to come up with the funds beyond the buyer’s “down payment”. Thus, the lender becomes an important party to the transaction.

Tip: View our blog post explaining “What is Important When Selecting a Mortgage Lender” to help you with finding a good mortgage lender.

Lenders need to know the fair market value of the property before committing to the loan amount. Lenders will conduct a property appraisal typically paid by the buyer. The appraisal protects the lender in case the buyer stops paying the loan leading to loan default and foreclosure of the property.

If the appraisal comes lower than the purchase price the lender can require the buyer to come up with the cash for the difference or rejects the loan. If this happens, the purchase agreement usually has a “contingency” canceling the purchase if the buyer fails to get financing.

At this point, the buyer could ask the seller to lower the purchase price to the appraised value. If the seller doesn’t agree, the buyer has these options:

  • Provide the lender with additional information on why the appraisal should be for a higher value;

  • Obtain a second appraisal;

  • Go to another lender hoping for a higher appraisal; or

  • Cancel the purchase due to inability to get financing.

Home Inspection

Home Inspection; Title Report and Insurance; Final Walk-Through; Reviewing the HUD-1 Form; and Escrow Closes

Tip: Never buy a house “as is”. Unless you are a seasoned investor or a general contractor, buying “as is” means just that. If you find defects in the home, you can’t back out of the purchase because it's “as is”. Always get a home inspection and make it a contingency with your purchase.

Buyers pay for their home inspections. It’s worth it. Spending a few hundred dollars to find expensive defects will save you thousands of dollars. Plus, it gives you the right to cancel the purchase if the seller refuses to fix them before the closing. Or, you can ask the seller to lower the price so you can hire professionals to make the repairs.

Title Report and Insurance

Lenders require a title report and title insurance. Even if you pay “all cash” you should get a title report and insurance to protect yourself from shady sellers or other parties claiming rights to the property. The title search and report verify if the seller is the only owner with the right to sell. Title insurance protects you after you take the title if someone else claims to be the real or a partial owner.

Final Walk-Through

Always re-inspect the home just before the closing to make sure the seller left promised items (appliances, furniture, etc.) and no damages occurred after the first home inspection.

Reviewing the Final Settlement Statement

Carefully review the Final Settlement Statement or (HUD-1 Form) presented by the escrow officer. It contains the purchase price, EMD credit, other down payment credits, and lists all your fees and costs. Make sure they are correct as mistakes and excessive or unexpected fees may pop up.

Tip: Read our blog post about “How To Understand California Escrow Costs to help you with understanding the Final Settlement Statement.

Escrow Closes

The closing requires you to sign several documents which require careful reading. The seller signs different documents. Once both parties sign all documents the escrow officer prepares a new deed naming you as the new property owner which gets filed with the county recorder.

As for pending costs and fees, you either pay with a bank wire transfer or a bank cashier’s check.

Tip: Read our useful blog post titled: How To Lower California Escrow Closing Costs to save money.

Note: This concludes your traditional mortgage escrow closing. However, if you got an FHA mortgage loan, extra procedures exist.

FHA Loan Escrow Procedures

The Federal Housing Administration (FHA) loans require a separate escrow account for paying homeowner’s insurance, property taxes, and Mortgage Insurance Premiums (MIPs). The MIP is an insurance policy required by the FHA added to your monthly mortgage payments. This insurance offsets the lender’s losses if you default on future loan payments.

What is Escrow? – Conclusion

Opening an Escrow Account; Earnest Money Deposit; Apply for Financing; Lender’s Approval

Now that you learned what is escrow, we hope you feel more secure about the safety of your funds during the escrow process.

The 9 steps explain the entire escrow process:

  1. Opening an Escrow Account;

  2. Earnest Money Deposit;

  3. Apply for Financing;

  4. Lender’s Approval;

  5. Home Inspection;

  6. Title Report and Insurance;

  7. Final Walk-Through;

  8. Reviewing the HUD-1 Form; and

  9. Escrow Closes.

Interested in Buying a Home in San Diego?

SoCal Lifestyle Realty provides you with experienced Realtors to find your dream home in beautiful San Diego County.

Contact us to find out about our unique RealScout home finder’s program which saves you time by sorting through the entire local MLS listings to locate your specific desired home features.

Steven Rich, MBA – Guest Blogger

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