Homebuyers dream about saying those magic words -- "We're in escrow!" -- but might wonder what escrow means and what purpose it serves. Escrow is an important part of the mortgage and lending package, but understanding it can be tricky. Essentially, escrow serves as a middle ground between the buyer and the seller, where a third party holds onto the paperwork and money on their behalf until the transaction is complete.
When you purchase a home, a portion of the money you provide to your lender goes into an escrow account, which your lender uses to pay for your homeowner's insurance and property taxes.
Usually, earnest money -- which is the initial payment many homebuyers make to show their serious intent to purchase a home -- and some of the closing costs fund the initial escrow account. After that, escrow payments are included in your monthly mortgage payments rather than paid upfront. Escrow accounts ensure that your essential bills and taxes are paid annually to avoid late charges or defaulting on your mortgage.
Escrow accounts are used for more than just homebuying and monthly mortgage payments, however. There are two other common uses for escrow accounts you might encounter:
Landlords and renters: Some landlords use escrow accounts for their renters to cover maintenance costs, utilities, or other expenses associated with the property.
Purchasing services or goods: Escrow accounts can help ease the stress of any type of purchase. They're particularly useful for transactions between strangers. This way, a third party holds the money until the service is complete or the product has been delivered.