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What is Escrow?

definition

Escrow is a process in large financial transactions in which payment is set aside and not delivered until all conditions for the transaction have been met.

🤔 Understanding escrow

Escrow is a process in large financial transactions in which payment is set aside and not delivered until all conditions for the transaction have been met. It’s often part of buying a home, but it can arise in other significant financial transactions, like corporate acquisitions. The buyer makes payment not to the seller, but to an outside third party. The third party holds onto the payment until a certain time or until the seller has done everything the two sides have agreed to. The third party then releases the payment to the seller. It’s a means of guaranteeing that a transaction is completed in a way that satisfies both sides. Homeowners may also use escrow accounts to set aside payments for property taxes and insurance until they come due.

example

Imagine that Brad and Michelle are buying their first home. They’ve found the perfect house, and the seller has asked them to put up “earnest money,” a deposit to show the seller that Brad and Michelle are serious about their purchase. The money goes into an escrow account until the sale of the house is finalized. Brad and Michelle’s money is then released from escrow and can be applied toward their down payment or closing costs.

Takeaway

Escrow is like a “Do Not Open Till Xmas” gift...

Escrow is something given by one person and intended for another, but it’s set aside and isn’t delivered until certain conditions are satisfied. That’s like a Christmas gift that can’t be opened until it’s Christmas. The condition that has to be satisfied is for Christmas Day to arrive. Once it does, the restriction is lifted and the gift can be opened - or the escrowed assets can be conveyed to the person for whom they’re intended.

Tell me more...

How does escrow work?
How is escrow used in real estate transactions?
How is escrow used with existing homeowners?
How does escrow work in online purchases?
How does escrow work with sales and payments of stocks?

How does escrow work?

In many large financial transactions and sales, escrow is part of the contract between the two parties. It assures both sides that the other party is going to stick to their word in completing the transaction.

Typically, one of the parties in a transaction pays money or other assets into an escrow account that is held by an outside third party, known as an escrow provider or agent. In doing so, the two sides agree on what has to happen for each party to recover the money in the account. Until then, the assets are “held in escrow,” where neither side has control over them.

In the case of a large purchase like a home, a buyer might want to have the purchased item inspected before committing to the deal, to make sure it’s in good condition. In turn, the seller may want to make sure the buyer has secured the necessary financing to complete the purchase. So money from the buyer that will go toward the sale goes into an escrow account. It proves to the seller that the buyer is ready and willing to buy. And it allows the buyer to keep their money safe until they know that what they’re buying is what they expected.

Escrow can also be useful for service-based businesses where the service costs a lot of money. The person buying the service doesn’t want to pay until the work is complete. The person providing the service wants to make sure the buyer doesn’t stiff them after they’ve done the whole job. Putting the buyer’s payment into an escrow account protects both parties.

If the conditions for releasing money from escrow aren’t met, the sale agreement can be canceled and the amount held in the escrow account is returned to the buyer.

How is escrow used in real estate transactions?

Real estate transactions are one of the areas in which escrow is most commonly used. When someone is selling a house, they often ask prospective buyers to put down “earnest money,” an amount to demonstrate to the seller that they’re serious about buying the house. The earnest money goes into an escrow account, to protect the interests of both sides: If the buyer could take back the earnest money, they could simply back out of the sale without any repercussions. If the earnest money is paid to the seller, they could keep it even if the buyer has a valid reason to not go through with the sale. By putting the money in escrow, neither the buyer nor the seller can go back on their commitment to get the sale done without suffering repercussions.

If the deal goes off without a hitch, the buyer gets the money back to put toward the purchase of the house. If the buyer backs out of the sale, they usually lose the earnest money. There are some situations where a buyer can back out and still get their money back, however. For example, if a home inspection finds serious problems with the home and the seller won’t fix them, the buyer can often back out of the sale without losing their money.

How is escrow used with existing homeowners?

While the escrow account you use when buying a house is only temporary, you might also have an ongoing escrow account after you own the home, to hold payments for your property taxes and homeowner’s insurance.

The monthly payment you make to your mortgage lender often includes not only the principal and interest on your home loan but the money to pay taxes and insurance premiums on the home. These taxes and premiums are typically paid once, twice, or four times a year, but lenders often charge you for those expenses on a monthly basis, with the money going into an escrow account. It then gets paid to the appropriate government or insurance company at the time it’s due.

Lenders do this because it’s in their best interest to make sure you make your tax and insurance payments on time. Let’s say you have a mortgage where you have 20% of the equity in your home, and the bank has 80%. If the house burns down, and you haven’t been paying your homeowner’s insurance premiums, both you and your bank could lose that equity. So the lender may bill you for the necessary funds so they can be set aside for when the payments are due.

If your lender sets up an escrow account itself, you don’t have to do anything beyond paying what you’re billed. If it doesn’t, you can either budget for the expenses appropriately yourself, or request that your lender use an escrow account.

How does escrow work in online purchases?

The home-buying process is the most common use for escrow accounts, but it’s not the only use. Escrow accounts can also be used in online sales, to create added security when a buyer is purchasing an item from someone they don’t know.

It would be easy for online sellers to scam people - they can claim online to be selling something of value, a seller sends them money, and the scammer never sends the item. So a buyer could request that their payment be held in escrow as a condition of moving forward with the sale.

There are also online marketplaces that have a built-in escrow system. The seller lists an item for sale, and a buyer makes payment for the item into an account run by the online marketplace. The marketplace then alerts the seller that they’ve received the money, and the seller ships the item. When the buyer receives the item, the marketplace releases the money to the seller. If the item never arrives, the marketplace may investigate, or release the funds back to the seller.

One example of such a marketplace is Reverb, an online marketplace for musical equipment. Using the Reverb Payments system, they release the payment to the seller only when the product has been successfully delivered. If that’s not the case, they can refund the money to the buyer.

How does escrow work with sales and payments of stocks?

Escrow can also be used in the sale and transfer of shares in the stock market. In some situations, shares can go into an escrow account for a particular amount of time, and the owner of the shares is not allowed to sell them during this period.

This might happen when a company issues shares to employees or executives as part of their pay package, or as a benefit. The shares might be restricted, meaning the employee can’t do anything with the shares until a specified vesting period has passed, possibly a year or more.

During the vesting period, the shares sit in escrow. Once that period passes, the employee owns the shares without any restrictions and can sell them if they choose.

Companies might also put shares or other assets into an escrow account as part of the payment in a merger with or acquisition of another company. The buyer might request that some of the shares it’s paying go into escrow until the deal is completed and the buyer knows everything has gone smoothly.

Escrow can be particularly useful if the sale faces any contingencies, such as approval from a government authority. The seller might also request that shares go into an escrow account until the buyer has fulfilled certain performance milestones.

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