A buyer wants to ensure that what is being bought is worth the price. The value of some property, such as stocks, is easy to ascertain, because stock markets are legally required to provide adequate information, which is readily available on the Internet. Real estate, on the other hand, is much more difficult to evaluate. Both the property and the title to the property take time to investigate. Consequently, there are many steps that a buyer and seller must follow to ensure an equitable transaction. Because of the substantial time involved in the investigation, neither the buyer nor the seller wants to waste time on people who are not serious about the transaction. Therefore, the seller would often want earnest money as a deposit to ensure that the buyer is serious about the purchase. The amount of the earnest money deposit will vary according to locale, but the buyer can determine the usual amounts from a real estate agent or attorney.
On the other hand, the buyer's agreement usually has many contingencies that will allow the buyer to back out of the contract or to renegotiate contract if either the property or the title are not satisfactory. Oftentimes, disputes arise. And there are trust issues. The buyer does not want to hand over money to the seller without knowing that there will be no problem in getting the deposit back if things prove to be unsatisfactory. Therefore, to facilitate real estate transactions, a disinterested 3rd party is usually involved in mediating transactions between the buyer and the seller. The process of using the third party is known as escrow, and the 3rd party is often called the escrow agent, or closing agent. Escrow minimizes the possibility of fraud and maximizes adherence to the terms of the agreement, because the escrow agent coordinates the closing activities and verifies each step of the closing process. The escrow period is the time from signing the contract to the final real estate closing. Either party or even the real estate agent can select the escrow company, but whether the buyer or seller selects the company customarily depends on the geographic region.
The escrow agency may be a title company or an escrow company, or an attorney. The escrow agent will naturally charge a fee for her services, and there may also be separate fees for the recording of documents, making wire transfers to pay off existing mortgages, mailing costs, and other such costs.
The exact details of escrow depend on state law and local custom. Generally, the escrow officer works for either an escrow company or a title company. In some parts of the country, attorneys may act as the escrow agent. The escrow instructions are an important part of escrow, since the escrow agent will resolve any disputes and will only undertake what is specified in the escrow instructions, derived from the purchase agreement and any other documented agreements between the seller and buyer. If either the buyer or the seller wants to change some provisions, then both must agree to the change.
When the seller accepts the offer from the buyer, the purchase agreement is signed, and the seller usually starts escrow by sending the purchase and sale agreement, any assignments of contract, and written escrow and closing instructions to the escrow agent. Earnest money from the buyer is deposited with the escrow agent in the name of the buyer. Then the property is under contract. After the escrow instructions are signed by both parties and returned to the escrow company, escrow is officially opened. The buyer, seller, and any lender will have separate escrow instructions, although some states allow joint escrow instructions. Thence, the buyer controls the property, allowing him to determine whether the seller has accurately represented the property.
The buyer, seller, and the escrow agent are legally bound to the terms of the escrow instructions, so any changes will require the consent of both buyer and seller. The escrow will be assigned a file number and, if a company is involved, to a particular escrow or closing agent, who also may be called a title officer or a settlement agent.
After the escrow instructions are signed, the buyer receives the preliminary title report that shows the current legal owner of the property, mortgage liens, unpaid income tax liens, property tax liens, judgment liens, recording encumbrances, easements, restrictions, or other third-party interests limiting the use of the property such as the CCR's — covenants, conditions, and restrictions. The preliminary title report will generally show whether the seller has a marketable title. That the buyer must approve of the title report is one of the primary contingencies in real estate transactions. If the buyer does not approve, then the seller must either cure the defect or lower the price as compensation.
The escrow agent will generally estimate the closing date of the transaction. Because delays are frequent, many contracts provide for an additional extension, often 14 days, without additional cost to the buyer, if the extension is necessary because of events beyond the buyer's control, such as potential environmental issues, delayed appraisals, or satisfying loan requirements. If the buyer wishes to extend the time beyond that, then additional money must be paid to the seller to cover the cost of continued ownership, such as mortgage payments, and the buyer will often make a down payment or release the earnest money to the seller as a show of good faith.
The escrow agent:
- gathers escrow instructions, filling in any missing information;
- issues receipts for deposits of funds;
- orders a title search that is later compiled into a title report;
- gathers payoff amounts from the lenders who are owed money on the property;
- gets releases from the lenders for mortgages or deeds of trust that must be paid off in escrow;
- takes the requisite steps to remove any outstanding liens on the property;
- obtains title insurance for the buyer and also for the lender, if there is one;
- returns loan packages to the lender with the needed signatures;
- prepares closing statements, and pro-rates taxes, interest, and rents on the property;
- prepares closing documents for signatures;
- disburses funds to the appropriate parties;
- records all documents that finalize the closing, such as mortgages, deeds of trust, grant deeds, reconveyances, and powers of attorney.
A title search may take time, but it will reveal any liens or encumbrances on the property that must be paid off or cleared before the title can transfer. Unexpected liens, those the seller has not disclosed, often occur with financially distressed property owners.
The federal Real Estate Settlement Procedures Act (RESPA) requires that escrow agents use the Uniform Settlement Statement (HUD – 1) form to itemize all charges and expenses in the real estate transaction if the loan for the property is either issued or insured by the federal government, including all bank loans with deposits insured by the federal government and all real estate loans insured by federal agencies such as the FHA or the VA and loans that will be sold to Fannie Mae, Freddie Mac, or Ginnie Mae.
RESPA prohibits kickbacks and referral fees to real estate agents or appraisers, or other professionals involved in the transaction for referring the borrower to a lender. Both the buyer and the seller must receive a copy of the HUD – 1 at least one day prior to settlement. However, the form can contain mistakes, which are often corrected. Some costs, such as the cost of repairs that are still in in progress may not be finalized until completion, so they cannot be added to the HUD – 1 until then.
The estimated closing statement will show the amount of money expected from the lender or from the seller, if the seller is financing part or all the transaction. It will also show how much the buyer is expected to bring in and must be in the form of a wire transfer, cashier's check, or any other type of payment that can be quickly certified. A personal check is not an option, since it could take a week or longer to clear.
The buyer and seller should check and verify before closing:
- time and location of the closing;
- verify the preliminary or final closing statement, including closing figures;
- determine whether the buyer's funding is in escrow or that the buyer is bringing the funds to the closing;
- confirm that ownership documents and insurance are correct;
- do a final walk-through of the property.
Escrow Tips for the Buyer
- Tasks with contingencies that may fail should be completed before other items, so less time or money is spent if contingencies fail.
- Never rely on oral information from the seller, rely only on written information, so that it cannot be disputed later.
- Do not apply for new credit before closing, since it will have a negative effect on credit history, which the lender may check right before closing.
- Likewise, do not drain your bank account for large purchases, since the lender will want to ensure that you have the cash to close.