What Is Escrow, And Why Is It Needed? - Digest Your Finances (2024)

Let’s start off with an example. Pretend you’re about to buy a car off of Craigslist. The person that’s selling the car asks you to send them $10,000 before meeting up or even getting the keys first, would you pay them? Probably not! In the real estate world, escrow prevents a similar situation.

What is Escrow?

Escrow is basically a financial situation where two parties that are about to perform a transaction, enlist a third party to temporarily hold funds and documentation. This third-party is neither a buyer nor a seller. Basically they are the middleman!

That Middleman, helping facilitate the transaction, is the escrow provider. The provider is responsible for making the transaction safe, transparent, and avoid any issues. This provider makes sure is that both parties complete their portion of the transaction before finalizing the transaction.

Who is the Escrow provider?

Typically, the escrow provider is an agent within a title insurance company. Depending on your state, the provider might be required to be an attorney. In other states, the provider might be a completely separate company, separate from a title company in the real estate world.

If we scale it down a bit, escrow providers can be whoever the two parties want to be. These examples are from real estate transactions but can apply to any transaction that both parties need to be protected.

An example would be online third-party facilitators like eBay or Fiverr. On these platforms, a user purchases an item or service. The funds are held in escrow until the transaction is complete, the buyer is satisfied, then the funds are released to the seller.

Are escrow accounts mandatory?

This entirely depends on the transaction and the parties involved. In terms of Real Estate, escrow is almost always mandatory. This is because a real estate transaction involves a mountain of documentation and a very large amount of money.

Both parties in a real estate transaction want to make sure that it goes completely smoothly, and no money is lost on either side.

When it comes to property taxes and homeowners’ insurance, having an escrow is usually required if you have less than 25% equity in your home. If you have more than 25%, it then becomes optional.

As you can see, having escrow isn’t necessarily mandatory, but in real estate, it usually is. Depending on the importance of the transaction, and the amount involved, it might not be optional.

Advantages of having an escrow account

Automatic

In the case of holding property taxes and insurance on your home, you don’t have to worry about paying those. This lets you avoid late fees and leans that could be placed upon your home. One less thing to worry about when it comes to finances.

Easier to be prepared

There’s nothing worse than a surprise bill in the mail. When it comes to your property taxes, does is added to your monthly mortgage payment. This means that your property taxes how old is covered, paid for it, and they will always be enough for it.

Layer of safety

When it comes to very large transactions, such as purchasing a home, this transaction is probably going to be the biggest transaction that you will ever do. By having escrow, you are protected against a lot of fraudulent activities, and it ensures that the transaction goes through smoothly and accurately.

Disadvantages of having an escrow account

Large upfront payment

In some instances, you might be required to set up a very large deposit. A homeowner for instance might be required to deposit several months of property taxes and insurance in advance within escrow. This means that, unless prepared, you might be require to place a large upfront payment.

Getting stuck in escrow

the thing is that, once under escrow, it might be hard to back out of it. Not that it’s impossible but it requires a large amount of paperwork I’m going through hoops. Getting into escrow in a contract means that there is some contractual obligations that both parties need to meet. So getting out of it is not usually and simple.

Risk of scammers

Since escrow accounts typically hold a very large amount of money, they are usually targeted by scammers. This puts escrow accounts as a target for scammers. Depending on the sophistication of the scammer, they might range from building fake phone call relationships to phishing sites.

Like it? Pin it!