Beyond the Mortgage: How an Escrow Account Helps You Realize Your Dream of Becoming a Homeowner
July 27, 2020
If you’re entering the home market for the first time, a house is likely to be the largest purchase you’ve ever made. But, no matter how much you fine-tune your price range when searching online listings, those numbers don’t reflect the actual cost of your dream home.
In fact, home purchases come with many somewhat hidden — and occasionally unexpected — costs. To ensure that your budget can cover them, you need to master a somewhat enigmatic concept: escrow.
Read on to learn more about what escrow is, how it factors into the total price of a home, the protections it offers both buyers and sellers, and why you may have to manage an escrow account for years after you’ve moved in.
What is escrow?
The term “escrow” refers to several distinct but closely related concepts. Escrow is:
- A legal process.
- A legal entity.
- A financial arrangement.
- A dedicated account that you may have to manage for the life of your mortgage.
Not only is buying a home a significant investment. As we’ll see, it’s also a complicated transaction involving credit checks, inspections, appraisals, transfer of property titles, loan pre-approvals and approvals, down payments, and much more.
Think of escrow as a holding period. During escrow, a neutral third party — an escrow agent — takes temporary possession of whatever money you’ve already committed to the home purchase and releases it to the seller once the many steps in the sales process have completed.
Moreover, a home purchase requires that all parties — buyers, sellers, and lenders — meet specific contractual obligations. The money in an escrow account will not be released until all of those obligations are met, thus protecting each party from any other party who chooses to act in bad faith. Examples of acting in bad faith include:
- A seller leaving the house on the market after accepting the buyer’s initial offer.
- A buyer failing to procure a home inspection and/or appraisal in a timely fashion.
As noted, the escrow process has many moving parts. Although we can’t cover all of them in this article, we can help you identify the big-ticket items you’ll need to tick off your escrow checklist.
Once you decide to purchase a home, you formally declare your intention to the seller by making both an offer and an initial deposit. This deposit indicates to the seller that you are acting in good faith, hence the name “earnest money.”
Your earnest money will eventually be applied as a credit, either to your down payment on the home or your closing costs (see below). Until then, your earnest money will be held in escrow either by a title company or the seller’s broker.
In most cases, the earnest money is non-refundable. If you do back out of your purchase agreement with the seller, you’ll have to forfeit your deposit. That said, in drawing up that purchase agreement, you can specify special considerations — contingencies —that will allow you to recoup your earnest money. The most common contingencies pertain to issues with the property as revealed during either the inspection or appraisal process.
How much cash will you need on hand for the earnest money?
The answer to this question will depend on the seller’s asking price. Earnest money is a negotiable percentage of that figure. In most cases, earnest money represents no more than 2 percent of a home’s listed price. However, that percentage may be higher in some highly competitive markets.
You’ve read and reread the online real estate listing. You’ve clicked through photos of the home’s interior. You’ve even taken a tour of its rooms during an open house. But a home inspection is an altogether different proposition.
A home inspector is a licensed professional who will spend between two and four hours examining the house’s interior and exterior for any structural, mechanical, or electrical issues. They will then create a comprehensive inspection report, complete with photographic evidence, documenting any areas of concern.
A home inspection produces more than a home maintenance to-do list, however. It gives you an opportunity to request that the seller either make home repairs before the sale is finalized or award you a concession. This negotiated settlement will allow you to pay for the repairs yourself once you’ve taken possession of the property.
If the home inspection uncovers major issues — especially any that the seller knew about but did not disclose before listing their property for sale — you may be able to back out of the purchase agreement without surrendering your earnest money.
How much does a home inspection cost?
Prices will vary according to the square footage of the home to be inspected. Texas home-buyers in the market for a single-family home measuring approximately 2,000 square feet should expect to pay between $300 and $500 for an inspection.
Your lender may require that an independent appraiser determine the value of the home you wish to purchase before approving your mortgage application. If so, you will have to cover the cost of the appraisal using your escrow account.
During the appraisal process, a licensed professional will confirm key facts and figures about the property (e.g., square footage, access to public utilities, etc.), evaluate the condition of the home, and survey its amenities, finishes, and furnishings. The appraiser will also review comparable sales, otherwise known as comps. That is, the appraiser will search through sales records looking for similar homes that have recently sold in the same area (usually defined as a one- to a two-mile radius around the home being appraised). By reviewing comps, the appraiser can make sure the value assigned to the property you’re interested in accurately reflects real market conditions.
If the appraisal value comes back at or above the agreed-upon sales price, you’re good to continue with the purchase. However, if the appraiser finds that the opposite is true, that discrepancy can spell trouble for your mortgage application. Lenders will not approve home loans for undervalued properties unless the seller is willing to renegotiate or the buyer can make up the difference. Ultimately, a low appraisal can lead to the cancellation of your purchase agreement.
Some debate surrounds the question of which should be performed first — a home inspection or a home appraisal. There is no prescribed order, and you can use your own best judgment when scheduling both. However, be aware that, in most cases, you will have between 5 and 10 business days to have this work performed.
How much does a home appraisal cost?
As with home inspections, the square footage of the property to be appraised will affect pricing. Texas home-buyers should add between $350 and $400 to their escrow account to cover the cost of appraisal services.
Preliminary title reports and title insurance
It probably comes as no surprise that buying a home means managing a lot of paperwork. A title report is among the most important of these documents. Compiled by a title company from state records and legal filings, a title report will typically include the following information.
- The names of the property’s previous and current owners.
- A legal description of the property, its boundaries (or property lines), and any adjustments made to those boundaries. The most common of these adjustments are easements and encroachments, the latter of which are more problematic.
- Zoning ordinances and permits relevant to the property.
- The property’s appraised value.
- Tax records related to the property.
- Encumbrances. An encumbrance is a claim on a property title exercised by a party other than the title-holder, such as a creditor. These claims can be non-financial in nature, but they often relate to unpaid debts such as mortgages and real estate taxes. Some encumbrances, including liens, must be cleared before the property’s title can be transferred to a new owner.
Unfortunately, any given title report might contain errors and omissions, either due to faulty record-keeping or intentional misleading on the part of the seller. Any encumbrances discovered after-the-fact could put you, the home’s new owner, at liability. Enter title insurance. This policy covers potential defects in the property title and protects you (and your mortgage lender) from claims that can lead to financial losses, foreclosure, or even repossession.
Although most insurance policies entail recurring payments, title insurance does not. Buyers pay the policy premium only once, and as part of the closing process.
You are not required to take out title insurance when purchasing a home. However, many home-buyers elect to do so for the peace of mind these policies can provide.
How much does a title report cost?
Title companies can charge anywhere from $75 to $200 to perform a property title search and produce a report.
How much should I pay for title insurance?
Title insurance premium rates are regulated by the Texas Department of Insurance (TDI). You can view these rates by visiting the TDI website.
As we’ve discussed, it takes more than a buyer and a seller to complete a home purchase. Realtors, inspectors, appraisers, surveyors, contractors, credit reporting agencies, lenders, lawyers, title companies, and many others have significant roles to play in this process. They also must be compensated for their time and effort. But those fees are most often due only once the home sale is final — your closing date.
We’ve already described several of the expenses, such as appraisal fees and title insurance premiums, that are customarily included in closing costs. But closing costs neither begin nor end there. The following are just a few of the other fees you may need to budget for when deciding how much money to put in escrow.
- Courier fees.
- Lender application fees.
- Origination fees.
- Recording fees.
- Underwriting fees.
You can find a comprehensive breakdown of closing costs at the Investopedia website.
Closing costs are negotiable, and you may even be able to convince the seller to pay for some or all of them — especially if they’re highly motivated to sell. Discuss your estimated closing costs with your lender when establishing the terms of your mortgage.
Some mortgages are advertised as “no closing cost” mortgages. However, they often carry higher interest rates. Alternately, lenders who offer these mortgages may average the costs across the life of your mortgage, in which case you’ll be paying interest on those nonexistent costs.
How much money should you have in your escrow account to cover closing costs?
All told, and on average, closing costs total between 2 and 5 percent of your home’s purchase price.
Congratulations! You’ve done it — you’ve purchased a home. But that doesn’t mean you no longer need to manage an escrow account. Your lender may require that you keep that account open to cover large annual expenditures such as your homeowners’ insurance premium and property taxes. Borrowers whose home loans are backed by government entities such as the Federal Housing Administration (FHA) and the United States Department of Agriculture (USDA) must also open a mortgage escrow account.
The chief advantage of a mortgage escrow account is that it allows you to pay for your real estate taxes and insurance premiums in regular installments. A mortgage escrow account can also help you simplify your finances. Instead of tracking multiple bills, each sticking to its own schedule, you make a single monthly mortgage payment covering principal, interest, taxes, and insurance (PITI).
One of the disadvantages of a mortgage escrow account is that, in Texas, it cannot earn interest. You may decide that you would be better off placing the money that would otherwise go into escrow into an interest-bearing account — again, assuming the terms of your mortgage permit you to do so.
Finally, the TI portion of PITI — taxes and insurance — is based on estimates. Paying the minimum amount each month can still lead to shortages when those tax and insurance bills come due. To cover those shortages, you may have to pay a lump sum. Alternately, your mortgage servicer may amortize the difference, resulting in a temporary increase in your monthly mortgage payments.
If you’re ready to put down roots in Texas, know that the mortgage team at Guaranty Bank & Trust is here to help. They understand the home-buying process inside and out and are experts in finding the right loan — featuring the best rate, the friendliest terms, and the lowest closing costs — to meet each borrower’s individual needs. Contact our Customer Care Center at (888) 572-9881 or book a video appointment today to learn more.