DEFINITION: The term “escrow” refers to an arrangement, often prescribed by law, in which one or both parties to a transaction entrust assets to a third party, who holds them on their behalf until the transaction is successfully completed.
Escrow funds will be deposited by the third-party agent into an escrow account. The agent will then manage the account, releasing specified quantities of the assets (often, but not exclusively, in the form of cash), either upon satisfaction of certain contractual stipulations or upon receiving appropriate instructions from the parties involved.
ETYMOLOGY: The English noun “escrow” is attested from the late sixteenth century. It derives from Middle French escroue and Old French escroe, meaning “parchment scroll.”
The related English verb “to escrow,” meaning “to place in escrow,” dates from only 1949.
USAGE: Escrow is mainly used in situations where there is uncertainty about the fulfillment of the respective obligations of the parties to the transaction.
Escrow is especially useful in certain types of transactions, such as those involving banking, real estate, mergers and acquisitions, legal matters, the Internet, and intellectual property, among others.
Why is this?
To understand the usefulness of escrow, imagine a company engaged in the trade of some luxury item, such as antiques. A customer places an order with the company for delivery of, say, a Ming vase.
Since fine porcelain is fragile, there is a degree of uncertainty surrounding this transaction. The customer wants to make sure it receives its vase in good condition before it coughs up the money. The company, in contrast, wants to make sure it gets paid for the vase in a timely manner.
Using an escrow agent can satisfy both of these needs at the same time. But it is the uncertainty, or risk, inherent to the transaction that is the real driver of the need for escrow in the first place.
First, the customer places the funds with the escrow agent. Next, the company ships the vase. Third, upon hearing from the customer that the vase has arrived in good condition, the escrow agent releases the funds to the company.
If a dispute should arise, the escrow agent would continue to hold the funds until the dispute is resolved.
In this way, escrow turns an inherently uncertain or risky transaction into one which is comfortable for both parties.
Real Estate Escrow
Real estate is the field of commerce in which escrow accounts are most often used. Two different basic types of escrow account are in common use in this field.
Before closing: By depositing a specified amount of money (usually one or two percent of the purchase price of the home) with a bank or real estate agent, the prospective buyer can demonstrate to the seller his good faith intention to make the purchase, pending the satisfaction of some requirement, such as the house’s passing an inspection or the performance of due diligence. In other words, the escrow payment is used by the prospective buyer to give the seller an incentive to wait—essentially, to hold his place in line—for a short time. If the buyer nonetheless decides to walk away from the deal, he may forfeit the escrow money unless he can show a sufficient cause for doing so.
At and after closing: Escrow accounts are also commonly created during the closing process for the purpose of receiving periodic payments towards required annual expenditures related to ownership of the property, notably homeowners’ insurance premiums and real estate taxes. Such escrow account payments are commonly structured as a dedicated portion of the monthly mortgage payment, above and beyond the amount shown on the actual mortgage’s schedule of payments. The extra amount is arrived at by dividing the total insurance premium and/or real estate tax liability by twelve, in the case of monthly mortgage payments. All of this may be represented by the following formula:
total monthly mortgage payment = scheduled mortgage payment + escrow payment
This type of escrow account will naturally continue to exist throughout the life the mortgage.
Insurance and tax escrow accounts are usually required by the bank or other lender that is being repaid by means of the monthly mortgage payments. The purpose of such accounts is to put the payment of insurance premiums and tax liabilities under the direct control of the bank itself. In this way, the bank protects the integrity of its principal security for its loan: the borrower’s property.
Escrow can also be associated with an escrow account established during mortgage closing. In this case, the escrow account is designated to cover future payments for homeowners’ insurance and property taxes.
An escrow account for the payment of insurance premiums and tax liabilities is advantageous for the borrower, as well, seeing that he need not worry about saving up to make those payments when they become due. His savings are made for him automatically though the escrow portion of his monthly mortgage payments.
In addition to real estate, escrow is used in several other fields, notably, in the issuance of stock shares to shareholders under certain circumstances and in the online sale of high-valued items.