There are two types of escrow when it comes to buying a home—one you'll use before you close on your home purchase, and another you’ll use after.
Escrow before you buy a home (escrow account)
As a first-time buyer, the first type of escrow you’ll encounter is a legal holding account set up to hold your “good faith deposit,” also known as “earnest money” during the closing process with a third party. When the terms of your purchase agreement are met and the transaction closes, the money will be moved from escrow into the seller’s account.
Escrow is important for protecting both buyer and seller. As a buyer, if you’re in contract and the sale falls through because of a problem found during inspections—say you discover the home needs a new roof or electrical system and that was not disclosed—you can get your deposit back from the third party. If you had instead paid it directly to the sellers, there’s a chance they wouldn’t return it.
On the flip side, if the sale falls through because you as the buyer decided to back out for other reasons—maybe you find a house you like better, or you get cold feet about mortgage payments—you might not get that deposit back.
Escrow instills confidence in the process of transferring funds and property. In addition to the earnest money transfer, escrow is used to transfer the deed and any other important documents.
When escrow closes, that means your home loan has been approved, all funds have been transferred to the buyers, and you are now the legal owner of the home’s title and deed.
Escrow after you buy a home (escrow payment)
Your mortgage lender has a vested interest in you making tax and homeowners insurance payments on time. So the lender will establish an escrow account, holding a portion of your monthly mortgage payment to pay those bills for you when they’re due.
Your mortgage lender will determine these amounts based on the previous year, but since your taxes and insurance premiums can change over time, it’s possible you might put aside too much or too little.
If that happens, you might get an escrow refund (yay), or you could have to make up the difference (boo). Most lenders require you have at least two months of extra payments in your escrow account.
Do you need escrow payments?
Some lenders may require escrow payments for taxes and/or insurance. But if your lender allows it and you want to keep your mortgage payments as low as possible, you could try saving up for your insurance and tax payments on your own.
But the service is usually free, and it’s a good way to make sure you don’t come up short when faced with a big tax or insurance bill.
Sources: Rocket Mortgage, Zillow, Investopedia
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