What Exactly Is Escrow and How Does it Work?

During a financial transaction between parties, escrow is an arrangement wherein a 3rd party holds assets temporarily until all the terms of the agreement have been met. Escrow guarantees everyone adheres to their end of the agreement before funds are released from the escrow account, so it benefits all involved parties. If all terms are not met, the money does not change hands.

When Would You Need an Escrow Account?

Contracts with the following characteristics are commonly held in escrow:

  • When a transaction has a high value, such as when a home is purchased.
  • When a buyer must verify the quality of work before paying for it.
  • When a seller does not want to undertake substantial work without assurance of payment.

Escrow also makes it possible to complete a transaction in stages. For example, a buyer may wish to avoid paying the full amount for a project before it’s completed, but the service provider still deserves to be paid for each phase of the project. As such, funds can be partially released after specific time-based conditions are met.

What Are the Different Types of Escrow?

Let’s take a look at the various types of escrow transactions.

Online Escrow

When we conduct an online transaction, it’s not always transparent who we’re dealing with. Licensed third parties provide internet escrow services to protect both buyers and sellers.

During the negotiation process, an agreement is reached that includes the purchase price, delivery schedule, and return policy, and is submitted to the online escrow provider. Once the transaction has been completed and all terms have been met between both parties, the online escrow provider will transfer funds to the seller.

Real Estate Escrow

Escrow is often used in real estate transactions because it protects the buyer from purchasing a property that does not meet inspection standards, and it protects the seller from entering into an agreement with a buyer who does not have the funds to actually purchase the home.

As a buyer, you take a substantial risk if you don’t use an escrow account in your home purchase since a seller can cash a check immediately without addressing potential issues with the property.

An escrow account protects all parties in a real estate transaction: the seller, buyer, and lender. Pre-closing escrow accounts are held by third-party entities that have no connection to any of the other parties to protect everyone’s interest. These escrow accounts hold the funds and abide by certain instructions during an impending real estate sale. Once all steps are completed and all paperwork has been signed, an escrow officer will return the loan paperwork to the lender for a final inspection before disbursing the funds and closing the escrow account.

Escrow in a Merger & Acquisition

By holding a percentage of the transaction value in escrow accounts, the parties involved in a merger and acquisition can reduce the risk of fraud and increase transparency. Buyers may file a claim against the seller if the seller fails to meet certain terms of the agreement, whether regarding the exchange of assets or stocks.

An M&A escrow has two advantages:

  • It provides a mechanism for diffusing disagreements over the value of assets or stocks.
  • It can mitigate the risk associated with a deal by addressing post-deal issues.

Escrow is a safe, reliable, and efficient way to facilitate the transfer of funds between two or more parties.

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