In the real estate investing business, real estate investors need to be familiar with a number of important terms to make the most out of an investment and succeed in the market – one of these terms is escrow. If this term is new to you, then keep reading! In this blog, we discuss what escrow means, how it works, escrow accounts, their uses in the real estate business, what influences escrows, and whether real estate investors can and should avoid it.
What Does Escrow Mean in Real Estate Investing?
Escrow is the money that homeowners and real estate investors are required to set aside for payments of real estate property taxes and insurance, paid by a third party (usually a mortgage company or servicer). Basically, when real estate investors close on a loan to buy an investment property, they will need to put an amount of money in an escrow account. Real estate investors also need to make payments toward that account during the life of the investment as part of the monthly mortgage payments.
In other words, escrows are financial arrangements when a third party is hired to hold and control payments involved in a real estate transaction. Real estate investors (both property sellers and property buyers) and real estate agents should be very familiar with and have a complete understanding of this term before selling or buying a real estate property.
Related: Buying and Selling An Investment Property: Do’s and Don’ts
Uses of Escrow in Real Estate Investing
Escrows can be used for any business arrangement wherein a person has to submit something of value (an amount of money in the case of real estate) in advance for future use. In the real estate investing business, escrows are very useful when a large amount of money is involved, and a number of obligations need to be fulfilled before a payment is made. As a result, it makes real estate transactions more secure by keeping the payment in an escrow account. While money is ‘In Escrow’, the transaction can be safely carried out without risk of losing money due to fraud.
In addition, most the mortgage lenders require escrow accounts to minimize their risks. Escrows ensure that real estate investors pay their real estate property taxes and insurance. In this way, it protects the mortgage lender from losing the real estate property due to the failure of paying property taxes or lack of insurance.
Moreover, when real estate investors are in escrow, they receive annual statements from their mortgage lender that shows exactly how much money was put into their account and how monthly mortgage payments were distributed. Thus, escrows protect real estate investors from late payments.
Escrow Accounts
In the real estate investing business, an escrow account is set up by the mortgage lender who will hold the money from the real estate investor that will be used for paying real estate property taxes and insurance. These accounts are established in writing and are subject to certain conditions.
Escrows are handled by this third party to ensure that a conflict of interest will not arise between the real estate buyer and seller. An escrow account is opened when both the real estate buyer and seller of an investment property have come to an agreement on the selling price, the terms, and any other conditions they may have, and are thus ready to close the deal. Both parties have to sign all appropriate documents, and then escrow is ready to be opened.
In real estate investing, escrows don’t need to be opened for a set time period. An investment property can be in escrow for a long period of time or just a few days. This mainly depends on how complex and difficult the real estate transaction is.
When all conditions have been met, and everything is complete, a closing statement is prepared by the escrow holder. When the real estate buyer and seller receive all closing documents, and the money is distributed, the seller of the real estate property will receive a check for the sale of an investment property, and the real estate buyer will receive the keys to the property he/she has just purchased.
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How Does Escrow Work?
The mortgage lender requires borrowers who have less than 20% down payment on an investment property to open an escrow account. This account acts as a type of insurance for mortgage lenders who might be at risk of not recovering their money if the property is seized due to not paying taxes or if it is damaged.
Typically, the mortgage lender will request the real estate buyer to put two months of real estate property taxes payments and two months of insurance payment in escrow in advance – before closing on the loan. This money will be part of what is known in the real estate investing business as closing costs.
Related: What Real Estate Closing Costs Should I Expect Upon Closing a Deal?
Money in escrows doesn’t stay with the real estate buyer, and it doesn’t go directly to the seller either. Instead, the mortgage lender holds the money, and when the bills are due, it will distribute the money needed to make the payments.
As previously mentioned, a real estate buyer continues to pay into the escrow accounts each month as part of monthly mortgage payments. This enables the escrow holder to make payments for real estate property taxes and insurance over the life of the mortgage.
When the contract conditions 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, the escrow account is closed.
What Influences Escrow?
As you can already tell, two things generally influence the amount of money in escrow accounts in real estate investing: property taxes and insurance. Both factors can be adjusted annually, increasing or decreasing the required monthly mortgage payments to the escrow account.
Property Taxes
Real estate property tax is the most likely factor to affect escrows. When housing prices are rising rapidly, property taxes may be increased. If this happens, even a fixed mortgage loan may not collect enough in escrow accounts to cover the tax increase, which results in a higher payment.
If property taxes are lowered, on the other hand, real estate investors probably would not see any change to their escrows and monthly mortgage payments. Instead of adjusting monthly mortgage payments, the escrow holder would issue a refund of surplus escrows after the real estate property taxes and insurance payments are paid.
Related: What You Need to Know About Real Estate Taxes as an Investor
Insurance
Insurance is adjusted less frequently and, in some cases, will not be adjusted unless requested by the real estate buyer. Some real estate investors choose to keep their insurance the same as when they first purchased an investment property. However, it is wise to reevaluate insurance coverage annually – and therefore a part of the escrow account and monthly mortgage payments – to make sure it matches your changing needs.
Can Real Estate Investors Avoid Escrows?
In some cases, yes. Some mortgage lenders allow real estate investors to pay property taxes and insurance payments on their own, especially if their loan-to-value ratio is below 80%. However, in this case, the mortgage lender might increase your interest rate to compensate for the risk it is assuming.
Once escrows are opened, it can be difficult to convince the mortgage lender to cancel them. However, you can eliminate an escrow account once you’ve paid down the principal of the mortgage and have at least 20% equity in an investment property. Nevertheless, keeping the money in escrow accounts for the entire set period of time is beneficial as you don’t have to worry about property tax and insurance payments as separate bills.
Should Real Estate Investors Avoid Escrows?
The simple answer is: It depends. There are always different reasons for different people. Nevertheless, real estate investors should keep in mind that without an escrow account, they have to pay real estate property tax and insurance bills when they’re due, and often times they are large sums. Before determining whether or not you need to open an escrow account, ask yourself: Am I a good saver? Where else can I put my cash? Can I handle monthly mortgage payments? And will it make a difference with my bank?
Conclusion
Escrows in the real estate investing business are very beneficial for all parties involved in a real estate transaction. You could say that an escrow account is similar to a savings account as the money deposited into this account is saved for a specific purpose. It protects real estate sellers from losing their money over fraud, ensures real estate buyers that their property taxes and insurance are paid, and minimizes the risk for mortgage lenders of losing an investment property.
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