Saving up for and selecting your perfect house is a long but rewarding process. The actual buying process is tough, and first time home buyers often don’t know what they’re in for. Buying a house is a multi-step financial and legal process. From buyers to sellers, there are securities and assurances that exist on both sides, and making sure the deal goes through legitimately is a tedious task. This process makes it a necessity to have a contract, lawyers, and a special bank account (known as escrow) to make the deal go through successfully.
What is escrow?
Most people have never come across this term until they’re in the process of purchasing a home. In a nutshell, escrow is when a neutral third party holds onto money or valuables during a transaction; or where the earnest money goes. The reason people do this is to protect themselves from being scammed. By nature, real estate involves large sums of money, and having a third party hang onto it will prevent either party from taking off and running. Think of it like selling a concert ticket. The person selling the ticket doesn’t want to give it up until they’re paid, but the buyer doesn’t want to pay until the ticket is in hand, for fear that they’ll pay and the seller won’t give up the ticket. So, they need a middle man to handle the transaction safely and fairly.
What is earnest money and how does it relate to escrow?
You may have also heard earnest money described as a “good faith deposit.” Essentially, earnest money is the buyer’s investment in the purchase. So for example when a buyer starts negotiating, the seller will make a “good faith action” by pulling the house off the market. This is an investment on the sellers part in a way, because of the cost it could take to put the house back on the market should the deal fall through. A buyer will typically buy town 1-3% of the home’s listed price as earnest money, and then money will continue to go into the purchase amount and be applied to homeowner’s insurance and property taxes should it fall through. If a deal is to fall through, the seller can then use that earnest money as fallback to help cover the costs of the relisting.
So, who holds on to the money? This is where escrow comes in. If a buyer holds on to the money, they could back out if they wanted to without any consequence. But if the seller holds on to it, they could back out of the deal and scam not one, but multiple buyers out of their earnest money. By having a neutral third party (typically a bank), hold on to the money, neither party can back out and run, and terms are put in place to make sure that happens. This means that buyers can put in a good faith deposit and both parties are protected from potential robbery.