What is an escrow and how does it work? Practical example

Along with mortgage payments you have property taxes and insurance premiums related to the house that are paid once or twice a year. To normalize the monthly payment many people choose to have these infrequent expenses paid through escrow (also in some contexts lenders may insist), so they pay a bit extra each month, that extra amount is held in escrow and used to pay the property tax/insurance premiums when due. If tax/insurance were $6,000/year they'd collect $500 extra in each monthly payment. These amounts adjust up/down with insurance costs/tax rates.

It's not a case of settlement risk in this context, but it does limit lender's risk since it decreases chances that the property is uninsured or has a tax lien.

Suppose I want to buy a house from person X. Person X is willing to sell me his house for 200 k$. I don't have this money, so I need a mortgage. I go to my bank to obtain a mortgage.

How does the escrow would work out in this practical example?

Let's try to imagine doing this without escrow.

Who should the bank give the mortgage money to? They can't give it to you, you might run off with it. And they can't give it to the seller of the house. What if they don't complete the sale?

How would the seller transfer the property? Would they get paid first? Who would trust them? Would they transfer the property and then trust you and the bank to provide payment?

And what if the seller has a mortgage already? They need to sign off on releasing the property to you. But they won't do that until after they get paid. But you don't want to pay anyone until you get title to the property.

What a mess.

Imagine if instead there was a third party that everyone trusted. You could give your payment to that third party, trusting them to return it if the sale falls through. The holder of the current mortgage could release the property as soon as the trusted party had the money to pay off the mortgage. And the seller could release their interest in the property as soon as that trusted party had the money to pay them. And if the deal fell through, everyone could trust that party to return the money to everyone appropriately.

That is the purpose of escrow in a home purchase transaction. It prevents you from having to do everything all at once.

The escrow doesn't really have anything to do with the mortgage itself, but in the United States it is a service most lenders offer to make payment of property tax and homeowners insurance easier. Tax and insurance are often paid annually or semi-annually and tend to be large lump sums, whereas mortgages are usually paid monthly, so they can be harder to budget for. As a convenience, the mortgage company will tack on the charges for the tax and insurance as part of the normal monthly bill and hold the money is escrow until those bills are due to be paid. Then they will pay the insurance company or government directly on your behalf using that escrow money.

To give a practical example, suppose you've purchased a house with a mortgage with a nice monthly payment you can afford. Since you own the house, you are now also responsible for paying $1200 a year for homeowners insurance and $2400 a year in property tax, both bills due once a year (a total of $3600 a year). To make things easier for you to budget and plan, the mortgage company adds an extra $300/month to your normal monthly payment bill and holds that money in a separate escrow account. Then, when those bills actually come due, the mortgage company will pull from that escrow account to pay the bill for you. This helps ensure that the money for these large and infrequent charges is always there and they get paid on time.

Not that it directly bears on the question, but since it has come up a number of times in comments and answers, there is another aspect to the use of an escrow account to hold tax and insurance money during the life of the loan.

Before I address that though, it is not necessarily a true escrow service as the mortgage owner may use a third party as the above seem to suggest or hold the cash themselves, as the above also seem to suggest. Or the holder may be an "arms-length" subsidiary. Probably those are the main variations, but there could be others too. How "arms-length"? Oh, whole other company of course, though, um, the employees there have career paths in the mortgage owning company so... You can clearly see I am not bucking the tide concerning evil mortgage companies, but also not trying to shade a decent, honest one. "One" being the operative word, but...

However, the other important thing about this kind of escrow account, and really the large reason why a mortgage owner insists upon it when they can, is something that might be unique to the US, might not. That is that the PROPERTY owes the taxes, not the owner. If I default on my mortgage, and it turns out I didn't pay the taxes for, oh, 3-4 years, or one semi-annual payment, whatever, the property owes that money, not me. The mortgage owner takes the property and sells it, but has to pay the taxes before the competent tax authority will allow the ownership transfer. No one can force me to pay it, through laws, though obviously, they have a contract that they can enforce with some lawyer-type effort and collect via that: Say $100,000 is still owed, it auctions for $108,000 (lucky me, really, 'cause it could've sold for a lot less in an auction). They have possession of the excess $8,000 and will apply it as they feel the contract allows and I'll have to sue if my reading differs. If that does not cover all the costs associated, they lose unless their contract allows them further recourse. (But if it does, I'd've declared bankruptcy instead and ganked them for a lot more so...) All that drama aside though, no matter what, if the property owes property taxes, they cannot collect anything from the buyer (unless he's foolish) until those taxes are paid.

There is a different concern vis-a-vis insurance and that is the fairly obvious: If the house burns down, they want it covered so they have something to auction! Or you have something you want to keep paying for instead of walking away. For physical harm losses, like you pay some neighborhood kid to mow the lawn and he cuts his foot off and the parents sue you, well, if you have a huge amount awarded, guess what house is being auctioned off by the sheriff BEFORE the mortgage owner's concerns matter? Escrow is a way (there is another way, much preferred by owners) of ensuring that there IS home insurance. But as a practical matter, the most common way for it to come up is someone does not pay their insurance bill, a deadline triggers, and the mortgage owner gleefully forces their own insurance policy upon the property owner (by contract) and the escrow for insurance arises. If one didn't pay the bill to start with, it's likely one didn't have the money to do so and now the mountain is higher. I digress there, but that is how it usually arises.

The downside for the mortgage owner is it then is responsible for making the actual payments. Not a problem where the insurance (very profitable) is concerned, but surely onerous where the taxes are. The downside for the property owner is that if they screw up a payment on the taxes, it is he the sheriff's deputies are forcing out of the house, not the mortgage owner and where the insurance is concerned, it will only be enough to pay off the loan, not to replace the structure/s. The mortgage owner is the payee, and the property owner the beggar. Further, though the loan balance goes down, anecdotal evidence says the insurance cost never does even though the covered amount has...

So, no, not really escrow, definitely not really "true escrow" in the sense of an entirely impartial middleman holding the money, but it DOES address real concerns of the mortgage owner and so they insist upon it when they believe they can without losing the business. And even sometimes then.

An escrow is not exclusive to a mortgage. Escrow can even be used when it is not money being exchanged.

Consider some possible risks in the process of purchasing property -- with or without a loan or mortgage being involved.

As the property seller, the buyer could scam me in the same fashion as Money Order and Check Depositing scams. Once the buyer has legal ownership of the property, the payment method is found to be fraudulent or reversed. As the seller I no longer have legal ownership of the property nor the money. The safest thing for me to do would be to retain possession of the property until the funds for the transaction have cleared and settled.

As the property buyer, the seller could scam me by providing the property fraudulently. Possibly the property is stolen, does not have clear title, or doesn't even actually exist. As the property buyer I no longer have the funds I provided the seller nor do I have legal possession of the property. The safest thing for me to do would be to retain the funds until I have irrevocable possession of the property and the state of the property is verified.

Because neither the seller or buyer can be satisfied with their optimal situations a third party, the escrow provider, is brought into the transaction. The escrow provider holds the funds for the seller until they have settled and cleared so they can no longer be revoked by the buyer. The escrow property also holds the property (or title to it) for the buyer until the state of the property is verified by the buyer. When both the buyer and seller are satisfied the escrow provider releases both parts of the transaction to the respective parties. If either the buyer or seller is not satisfied, the escrow provider will release both parts of the transaction back to the original parties. This reduces the possibility of the buyer being able to harm the seller or vice versa.

This is not limited to transactions involving money either. If Alice were to trade her highly valued sports car for Bob's highly valued SUV, both Alice and Bob would want to ensure that the respective vehicle was in the condition the other party claimed it was in as well as that the other party holds clean title to the vehicle. Neither Alice or Bob want to sign their title and hand it over to the other before the other in case the other party re-negs on their deal once they have what they want. In this scenario an escrow provider would hold both signed titles until both parties are satisfied (or not) as before.

This is also not limited to transactions involving two parties, such as a buyer's mortgage broker and seller's mortgage holder being a third and fourth interested party involved in the sale of real estate.

Here's a short description of how an escrow account for a mortgage works, without using complex concepts. I just bought a house and will use my own practical example with fake numbers.

To buy a house that costs $300,000, I make a down payment of $50,000 and then get a mortgage (loan) for the remaining $250,000 from my bank.

Each month, I pay the bank $1,500. $1,000 of that goes toward paying the $250,000 mortgage.

The remaining $500 that I send them each month gets put into an escrow account. It's like any other bank account, with a balance that increases when I put money in and decreases when the money is taken out for spending. I put that $500 in each month, and the bank will use the money in that account to pay for my home insurance and property taxes when they come due.

Property taxes are due every six months (this may vary by location), so using the escrow account to pay for them is beneficial to me. It means I pay a small amount every month ($500) instead of a big amount every six months ($2,500).

If you have ever used eBay or internet shopping between two individuals, it is an example of escrow. Both the buyer and seller want to complete a sale, but do not trust each other. If the buyer sends the money directly to the seller, the seller may run off with the money without sending the product. If the seller sends the product directly to the buyer, the buyer may run off with the product without sending the money.

A trusted third party, here eBay / PayPal, makes the transaction much more trusted. The buyer sends money to a trusted third party, here eBay, who holds onto it. eBay notifies the seller that the buyer has committed the money and tells the sender to send over the product. When the buyer has received the product, he notifies eBay who releases the money to the seller. Observe that the buyer must first commit money to eBay so it is guaranteed available to the seller, and if the seller never sends the product, eBay returns the money to the buyer.

This arrangement depends on a trusted third party. Incidentally, in illegal darknet markets selling things like drugs, exit scams are common where a third party establishes a reputation as being trustworthy, only to run off with the money buyers/sellers have in escrow before being shutdown. This has led to the development of decentralized marketplaces which operate without middlemen by use of so-called smart contracts.

Escrow solves the issue of trust between a buyer and a seller during a transaction.

From the buyer perspective - what happens if I pay the money but I dont receive the good ?

From the seller perspective - how do I know the buyer is serious and will actually pay me the money when I give them the good ?

Escrow is a trusted third party who will take the money from the buyer during an agreed transaction (in this case - a house), and pay the seller after the transaction is complete.

The transaction can be as simple as sending a wrist watch via Fedex, or as complicated as transferring the title on a house. Really, you can buy or sell anything via escrow if it is not practical for the good to be immediately exchanged for cash.

In many countries you can use an attorney for escrow, or a dedicated escrow company. For example in Europe there is a German company called "Pay and Relax Gmbh" for handling escrow payments, that can be completed on your mobile phone.

The key here is that both parties must have trust in the escrow provider. :)