There can be several purposes for setting up an escrow account. An escrow account is an account that temporarily holds funds for other parties, primarily for real estate purposes -- although other transactions may require an escrow account as well. An escrow company is a neutral third party that temporarily holds the funds, which are disbursed when specific terms and conditions have been met.
The most common type of escrow account is the impound account, or mortgage escrow account. This account is generally required by most lending institutions and holds your homeowner's insurance and tax payments, which are included in your house payment. This type of escrow account is also referred to as a "reserve" account, and is disbursed annually when your homeowner's insurance and tax payments are due. This arrangement helps to avoid any lapses in insurance or tax foreclosures due to nonpayment.
An offer to purchase real estate can initiate the opening of an escrow account. This account will temporarily hold funds for the buyer and seller. Items such as the earnest money deposit, prorated taxes, loan funds or after-closing repair costs can all be held in the escrow account until the closing. The escrow agent handling your transaction will pay off the seller's mortgage balance, tender proceeds to the seller and distribute other funds connected with the closing, such as title insurance premiums.
When building a new home, a bank will often use a construction escrow account. This account holds the loan funds for the builder until specific phases of the construction project are completed and pass inspection. Upon approval of each building phase, the builder will request a "draw" of funds to pay off building costs such as permit fees, contractor bids or excavation costs. This method helps the builder to not only stay on budget, but assists the lender in ensuring that all building costs for the home are paid in full.
Escrow accounts can also be used for seller-financed deals. This is usually highly recommended by real estate professionals. Instead of a buyer making payments to a seller directly, the monthly payment is made to a third party escrow provider, and then transferred to the seller. This enables the escrow collection company to accurately record all payments made and allocate these funds to the principal and interest of the loan. Not only does this help to account for all monies exchanged, but it also can alleviate any potential disputes between parties.
Meribeth Phipps has been a real estate broker since 2000, specializing in residential new home sales. She holds a bachelor's degree in business and marketing.