For many real estate investors and homebuyers, buying a real estate property is probably the most important investment they will ever make. It also means having to decide between the many real estate options available such as the property type, the investment strategy, the location, and the best way to pay the property taxes and property insurance each year. There is no simple exchange of money in a real estate transaction. However, one important aspect of real estate transactions that benefits real estate investors in this regard is escrow accounts.
What Are Escrow Accounts in Real Estate Investing?
In real estate investing, escrow is the money that real estate investors set aside for payments of real estate property taxes and insurance payments paid by a third party (usually mortgage lenders). Essentially, before real estate investors close on a loan to buy an investment property, they will put an amount of money in an escrow account and continue to make payments toward that escrow account during the life of an investment as part of monthly mortgage payments.
Related: Is Taking a Mortgage for Rental Property a Good Idea?
Escrow accounts are set up by the mortgage lender who holds the money that will be used for paying real estate property taxes and property insurance. The reason why escrow accounts are held by mortgage lenders as a third party is to ensure that no conflict of interest will arise between the real estate buyer and the property seller concerning monthly mortgage payments.
Escrow accounts have to be established in writing and are subject to certain conditions. Escrow accounts are opened when both the real estate buyer and the property seller of an investment property have agreed on the selling price, the terms, and any other conditions they may have. Both parties have to sign all relevant documents, and then an escrow account is ready to be opened. Escrow accounts are temporary as they operate until all the conditions between the real estate seller and the property buyer are met and the real estate transaction is completed.
Benefits of Escrow Accounts
For the Mortgage Lender
When a real estate investor uses a mortgage loan to buy an investment property, the property itself serves as collateral to secure the mortgage lender’s interest. Of course, the mortgage lenders want to minimize their risks of losing the real estate property due to liens or foreclosures, or accidents and damages. Failure to pay real estate property taxes can result in a tax lien or tax foreclosure. In addition, it might be too expensive to repair a damaged home without property insurance.
This is where escrow accounts come into play. They ensure that real estate investors pay their real estate property taxes and insurance payments. In this way, it protects the mortgage lender from losing an investment property.
Related: What You Need to Know About Real Estate Taxes as an Investor
For the Real Estate Seller
In the real estate investing business, escrow accounts are very beneficial when a large amount of money is involved in the real estate transaction, and a number of obligations need to be settled before a payment is made. When real estate sellers are aware that the money is in escrow accounts, they’re ensured that the transaction can be safely carried out without risk of losing money due to fraud. Thus, keeping the payment in an escrow account makes real estate transactions more secure.
Furthermore, when real estate investors are in escrow, they’ll receive annual statements from the mortgage lender showing exactly how much money was put into their escrow account and how monthly mortgage payments were distributed.
For the Real Estate Buyer
Arguably, the best thing about using escrow accounts is the convenience for the real estate buyer. Having just one payment to worry about each month means real estate buyers don’t have to write multiple checks or chase down receipts for real estate tax and property insurance payments. Moreover, real estate buyers living in a community with a homeowner’s association can add these fees into escrow accounts to simplify their monthly mortgage payments even further.
Mortgage lenders sometimes offer real estate buyers an incentive for setting up escrow accounts – such as lower interest rates – which can make a significant difference in the long run.
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How Escrow Accounts Work
As previously mentioned, escrow accounts are established to collect real estate property tax and property insurance payments. Each month, the real estate investor will have to pay the mortgage lender an additional amount on top of the monthly mortgage payments. This amount is placed into the escrow account until real estate property taxes and insurance payments are due. The mortgage lender will then pay these bills on your behalf out of the escrow account.
When the conditions set in the contract between the seller and the buyer are met, the escrow holder will pay the closing costs to the seller and transfer the investment property to the real estate buyer. At this point, escrow accounts are considered closed.
Do Real Estate Investors Really Need Escrow Accounts?
Not necessarily. Technically, real estate investors could pay their tax bills and insurance payments themselves if they’re responsible and disciplined enough, especially if their loan-to-value ratio is below 80%. Still, escrow accounts are great to have as they keep you safe from missing an important payment.
However, escrow accounts are unavoidable as mortgage lenders request them if you’re putting less than 20% down on a real estate property. Fortunately, real estate investors may be able to cancel escrow accounts down the line, and the best way is by building enough equity in the real estate investment property.
The Bottom Line
Escrow accounts in real estate investing are established to pay real estate property tax and property insurance as part of the monthly mortgage payments. Understanding escrow and the benefits of these accounts will help real estate sellers, real estate buyers, and mortgage lenders stay on the right side of the law and protect the real estate property from theft or fraud.
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