What is an Escrow?

An escrow is a financial and legal agreement, stipulating an independent third party to temporarily hold on to a sum of money or property on behalf of two other parties involved in a transaction. The monies or property held in escrow will only be disbursed when the obligations to the transaction are fulfilled. This protects the interests of both parties (buyer and seller) in a transaction as it eliminates the uncertainty over whether either party involved in the transaction will fulfill their contractual obligations, thus reducing the risk of fraud.

Read also: What is Loan-To-Cost (LTC) Ratio?

How does an Escrow Work?

Take for example a firm that sells goods internationally. After one party has initiated a transaction, both buyers and sellers will need to agree to all the terms and conditions for the transaction to take place. The buyer makes a payment to the escrow account. Upon confirmation of payment, the seller sends out the merchandise to the buyer. The buyer inspects the goods to ensure that it is in a suitable condition before accepting it. Once acceptance of goods is confirmed, the escrow officer will disburse the payment held in the escrow to the seller.

If the buyer is not satisfied with the condition of the goods, he can raise a dispute and enter into a dispute resolution process with the seller. In this case, the money in escrow will be on hold until further instructions are given.

Read Also: What is Debt-to-Equity(D/E) Ratio and What is it Used for?

How to set up an Escrow Account?

An escrow account can be set up via the website, phone call, email, or in-person visit to the escrow company as specified in the purchase agreement. In a real estate transaction, the seller's real estate agent typically sets up the escrow account. However, it is important to note that an escrow account can be opened by any party involved in a transaction, not necessarily the agent.

When opening an escrow account for real estate transactions, information required by the escrow officer may include, but are not limited to, the following:

1. Property street address
2. Sale price
3. Property type
4. Full names and contact information of all parties involved, including email addresses
5. Purchase agreement
6. Listing commissions
7. Selling percentage

Upon the receipt of a fully executed purchase agreement, the escrow officer will issue an escrow number. The transaction will then proceed once the buyer makes his initial deposit into the escrow account to secure financing and the title company enforcing the purchase agreement.

When is an Escrow Used?

1) Investment Transactions

The concept of escrow can be applied to an investment transaction, such as an investment in a P2P lending platform. Generally, investors investing in such a platform will not transfer their funds directly into the business account. Instead, the funds will first be placed inside an escrow account before they are released into the business account, upon fulfillment of all the terms and conditions by both parties. An escrow acts as a layer of protection to investors such that if the platform was to go bankrupt, the borrower's repayment of loans could still be guaranteed. The escrow agent will continue to collect repayment of the loans from the borrowers on behalf of investors.

2) Sales of Goods and Services

The concept of escrow can be applied to the transaction of goods and services, such as the sale of furniture from international wholesalers and suppliers. After a buyer has initiated an offer to purchase a set of furniture from an international furniture wholesaler, both the buyer and wholesaler agree on the terms and conditions such as the purchase amount, time for arrival of goods, and allowable return period of the goods. Both parties will then submit the documents to an escrow agent who will ensure the enforcement of all obligations, protecting their interests. The buyer will make payment for the furniture into the escrow account before the seller dispatches the goods. Once all terms are met, and the buyer is satisfied with the purchase, the escrow agent will then release the funds to the seller.

If any disagreement arises, a dispute resolution procedure will take effect and decisions on the rightful party that shall keep the monies for the transaction shall be made. With the rise in scams and cybercrimes, escrow is a trustworthy platform that facilitates and boosts goods and services transactions worldwide.

3) Real Estate Transactions

The concept of escrow can be applied to real estate transactions, such as in the sale of a house. After a buyer has made an offer to purchase a home, and the seller accepts that offer, the buyer typically pays a deposit to show his interest in buying the house. This money is usually made to the escrow account held by a third party by either the buyer or the real estate agent involved in the transaction. After the payment is secured, the seller proceeds with the house inspections, feeling assured that the buyer has sufficient funds to make the final payment. Upon fulfilling all conditions, the escrow officer will release the cash reserved in the escrow account to the seller.

If a house sale falls through due to the buyer's change of mind, the money placed in the escrow account will, say, be forfeited or deducted with a penalty to the seller, as per the bilateral terms and conditions. However, if the cause of the sale falling through is due to the seller not fulfilling his obligations, the buyer’s money will be returned from the escrow account.

Apart from this, when a borrower closes on a mortgage, the lender may also set up a mortgage escrow account. Lenders may deposit a portion of the borrower's monthly loan payment inside this account to finance part of the costs associated with homeownership, such as property tax and insurance premiums. In addition, the lender may make an additional payment to the escrow account to cover any unanticipated costs that the property may incur. Unlike the short-term escrow account used to purchase a home, the borrower employs the mortgage escrow account throughout the life (or term) of his loan.

Advantages of an Escrow

Escrow is beneficial as it protects the buyer, seller and lender in high-ticket transactions, such as real estate transactions involving large sums of money. In addition, escrow for mortgages allows a secured monthly payment of insurance and taxes to the relevant authorities, reducing the possibility of underpayment and late payment, which might incur additional penalty fee towards the homeowner.

Disadvantages of an Escrow

The downside of escrow is that payment into the escrow account is usually only an estimated figure; the lender may end up overpaying or underpaying into the escrow account. This is undesirable, and may lead to an adjustment in the annual payments. Moreover, for mortgage escrow, taxes and insurance premiums are subject to fluctuation. When any of these costs increase, the mortgage payment made by the borrower will also increase, resulting in a higher monthly bill (mortgage escrow account is usually funded through monthly mortgage payment) than it would have been without an escrow. In addition, once an escrow account has been set up between the lender and buyer, either party will face difficulty if they want to abolish it later.

Escrow vs Trust

Trust works in a similar way to an escrow in that both serve as a third party to the contract, protecting the interests of all parties. However, they may differ in terms of the role undertaken by the agent. An escrow agent is a neutral and independent third party from the buyer and seller involved in a transaction, with duties assigned by the agreement between the two whereas the trustee has a more flexible role, with the key responsibility of overseeing assets for a particular beneficiary's benefits, implying more tasks and power assigned to the trustee.

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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.