Understanding the Escrow Process and Requirements
Buying a house is full of complications that most people do not understand and are unprepared for. One of those mysterious elements is being "in escrow," which occurs between the time a seller accepts the offer and the buyer gets the keys to the new house. Below is a 10-step walk-through of the process, so you won't be left standing in the rain without a roof over your head.
1. Open an escrow account
Once you and the seller have agreed on a price and signed a mutually acceptable purchase agreement, your real estate agent will collect your earnest money (sort of like a good faith deposit, ultimately applied to your down payment) and deposit it in an escrow account at the escrow company or service specified in the purchase agreement.
An escrow account is managed by an outside party in order to hold valuables, such as money, property deeds and personal finance documents, on behalf of two agreeing parties until specified conditions are met during a financial transaction. Depending on the reason for escrow, the escrow agent may be a title company that specializes in real estate, a bank or financial institution; or a private individual may be entrusted with the role.
The escrow company acts as a neutral third party to collect the required funds and documents involved in the closing process, from the initial earnest money check to the loan documents to the signed deed. In some areas, attorneys may handle this process instead of an escrow company, in which case it's often called "settlement" rather than "escrow."
2. Await the bank's appraisal
Next, the bank or lender providing your mortgage will do its own appraisal of the property (which you, the buyer, usually pays for) to protect its financial interests in case it ever needs to foreclose on the property. If the appraisal comes in lower than the offered price, the lender will not give you financing unless you are willing to come up with cash for the difference or the seller lowers the price to the appraised amount.
Your other options to try to change the appraiser's mind are one of the following:
- to provide additional information on why you believe the home should be appraised at a higher amount
- to get a second appraisal
- to try going with another lender and hope that lender's appraisal comes out in your favor
If none of these options is possible, you will be able to cancel the purchase contract. (For more information on pricing a new home, read 10 Tips for Getting a Fair Price on a Home.)
3. Secure financing
You should have already been preapproved for a mortgage at the time your purchase agreement was accepted. Once you give your lender the property address, it will prepare a good faith estimate, or a statement detailing your loan amount, interest rate, closing costs and other costs associated with the purchase. You may want to negotiate the numbers on this document before you sign it.
Agents often also include home sale contingencies in purchase contracts to prevent buyers from simultaneously owning two homes and paying two mortgages. This type of contingency gives a buyer a specified amount of time in which to sell his current home before closing escrow on a new home.
4. Approve the seller's disclosures
During this step, you should receive written notification of any obvious problems that have already been identified by the seller or the seller's agent. For example, the garage may have been turned into a living area, in violation of city housing codes. You may already be aware of any problems like these because they're often mentioned in the listing.
5. Obtain the necessary inspections
You aren't required to obtain a home inspection when you purchase a home, but it's in your best interest to do so. For a few hundred dollars, a professional home inspector will tell you if there are any dangerous or costly defects in the home. If there are, you'll want to know about them so you can back out of the purchase, ask the seller to fix them, or ask the seller to lower the price so you can handle the repairs yourself. Note that you cannot negotiate any seller concessions here if the contract says you will purchase the property "as is." If the inspection process concludes satisfactorily, you will then need to remove the purchase agreement's inspection contingency in writing. (You'll repeat this step after any other inspections.)
If the lender does not require a pest inspection, you may still want to get one to ensure that the house does not have termites, carpenter ants, or other pests such as roaches or rats. These problems may not be apparent during the daytime hours when you've most likely viewed the house, and would be a terribly unwelcome discovery after you move in. If there are any pest problems, they will need to be rectified before the sale can proceed (assuming that you want to continue with the purchase). This is another area where you may want to renegotiate with the seller to pay for the work.
It is sometimes recommended to get an environmental inspection to check for toxins in the home such as mold and asbestos. There can also be problems on the home site, like contamination from a location near a landfill, former oil field, dry cleaner or gas station. Any problems uncovered in this area can mean serious health hazards and may be prohibitively expensive to fix.
Areas subject to earthquakes may require a soils report and/or a geologic report to assess the risk of serious damage to the property in the event of such a disaster. Many areas require flood reports. If the home is too likely to flood, you won't be able to get homeowner's insurance, which means you can't get a mortgage. In some cases, purchasing flood insurance in addition to your homeowner's insurance will solve this problem. In rural areas, a land survey should be done to verify the boundaries of the property (in urban areas, the boundaries tend to already be very clear).
6. Get hazard insurance
This includes homeowner's insurance and any extra coverage required in your geographic area (such as flood insurance). You will be required to have homeowner's insurance until your mortgage is paid off (and you'd probably want it, anyway). Choose your own insurance company, which may be different than the one the lender selects, and shop around to get the best rate.
7. Acquire the title report and title insurance
These are also required by your lender, but again, you'd want them anyway. The title report makes sure that the title to the property is clear – that is, that there are no liens on the property and that no one else but the seller has a claim to any part of it. Title insurance protects you (and the lender) from any legal challenges that could arise later if something didn't show up during the title search. If there is anything wrong with the title (known as a cloud or defect), the seller will need to fix it so the sale can proceed or let you walk away. Depending on where you live, the escrow company and the title company may be one and the same.
8. Do a final walk-through
It's a good idea to re-inspect the property just before closing to make sure that no new damage has occurred and that the seller has left you items specified in the purchase agreement, such as appliances or fixtures. At this point in the process, you probably won't be able to back out unless the home has sustained serious damage. However, it's not unheard of for a petty buyer to pressure his or her agent to get the agreement nullified over something insignificant.
9. Review the HUD-1 form
At least one day before closing, you will receive an HUD-1 form, or the final statement of loan terms and closing costs. Compare it to the good faith estimate you signed earlier. The two documents should be very similar. Look for unnecessary, unexpected or excessive fees as well as outright mistakes.
10. Close Escrow
The closing process varies somewhat by state, but basically, you'll need to sign a ton of paperwork, which you should take your time with and read carefully. The seller will have papers to sign as well. After all the papers are signed, the escrow officer will prepare a new deed naming you as the property's owner and send it to the county recorder. You'll submit a cashier's check or arrange a wire transfer to meet the remaining down payment (some of which is covered by your earnest money, remember) and closing costs, and your lender will wire your loan funds to escrow so the seller and, if applicable, the seller's lender, can be paid.
If you make it this far, you'll finally get to take possession of the home.
FHA Loan Escrow Guidelines
With traditional mortgages, your experience with escrow usually ends at this point. If you are buying a house with a Federal Housing Administration (FHA) loan, however, your dealings with escrow accounts continue – in a different way, for different reasons.
FHA loans require an escrow account be maintained for property taxes, homeowner's insurance and mortgage insurance premiums (MIPs) (the latter are required for borrowers making less than a 20% down payment). Rather than paying taxes directly to the government and insurance premiums to the insurer, an FHA borrower pays one-twelfth of these expenses each month, in addition to his mortgage principal and interest payment, into the account. The escrow account holds this money until the bills become due at the end of the year. At this point, monthly escrow payments for the following year are adjusted up or down based on whether there was a shortage or surplus in the account for the current year's payment. Mortgage-holders are obligated to send you an annual statement regarding the activity of your escrow account, which may also be referred to as a mortgage impound account.
Why all this? Because, to put it crudely, FHA loan applicants are considered higher risk: They often have lower credit scores, smaller incomes and fewer assets – all the reasons they are seeking FHA loans, which have less stringent requirements for borrowers than conventional mortgages, in the first place. Lenders are willing to extend mortgages to them because of the FHA backing, and the FHA is willing to back them. But it wants to ensure the bills get paid; hence, the escrow-account mandate.
The Bottom Line
Your real estate agent will oversee this entire escrow process, so don't be too concerned if you don't understand every detail. However, in any transaction where you're putting so much on the line financially, it's a good idea to have at least a basic idea of what's going on so you won't get taken advantage of – or inadvertently lose your dream home.