*****Disclaimer: This is not legal advice and is for educational purposes only. This does not create an attorney-client privilege.
In short, escrow refers to a financial and legal agreement in which assets are temporarily held by a third party, until all the terms of the contract in question have been met. This agreement is undertaken when the parties involved in the transaction enlist a third party to handle controlling assets or payments until the transaction is finalized. This third party is neither the buyer or seller, but a neutral party who releases funds contingent on the contract terms being met.
So what exactly are these “assets” that this third party institution is controlling on behalf of the two parties in the transaction? Well, first of it will be for high value assets; you wouldn't use escrow for some kind of small transaction. One type of asset could be payment; actual money. The asset in question could also refer to property.
In real estate, escrow is typically used for two main reasons. The first circumstance it would be used is to protect the deposit of a buyer. The buyer makes their payment in good faith, and the third party company holds onto this payment until all the conditions of the sale have been met. This type of escrow is specific to the process of buying new real estate properties.
The second major reason this would be used is to hold a homeowner`s funds for insurance or tax purposes. This kind of escrow account is used throughout the life of a loan. These accounts help homeowners to set aside money to cover property taxes, insurance premiums, etc. By doing this, you are able to avoid having to make a large, yearly payment and instead have a mortgage lender use money in your escrow account to cover payments as they come in throughout the year.
In real estate transactions involving buying a home, escrow is a critical stage in the process. The process is initiated when the buyer makes a good faith deposit, also known as earnest money, on a home. Usually the purchase agreement will require some kind of initial deposit; this is to ensure that the buyer is serious and ensure that the relatively long process of getting the title of the property transferred is not an effort being made in vain.
Usually, when a buyer makes a deposit, if the sale falls through for some fault or issue of the buyer, the person selling the home would get to keep the deposit. If the sale does proceed successfully, that deposit is generally applied toward the down payment on the property. So this deposit isn't some extra amount, but it does help affirm that a buyer is truly desiring and ready to proceed.
In order to protect both the buyer and the seller during this period, an escrow account will be created to hold that deposit until the process is finalized. It is not usually as simple as just exchanging some money and going straight to the home. One reason that might necessitate an escrow holdback on funds would be if you need more time to complete home inspections or for the owner to comply with bringing certain things up to code. A sale could also be contingent on the seller fixing certain issues found in the walk through; so escrow can sit on the money on behalf of the buyer until the terms have been met.
A final example of a common reason for escrow could be if the current family has not moved out yet. When someone sells their house, they might not necessarily have the new home ready for them yet. So a buyer could give their initial deposit and open escrow to make sure they have started the process and are essentially locked in and ready to go to finalize the sale, while they wait for the home to be made ready for them.