Real Estate Investing

The Intricacies of Escrow and Per Diem for Real Estate Investors

May 17, 2024

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Escrow and Per Diem

The real estate financing process can be full of pitfalls for new investors. 

One concept that new investors and homeowners are generally unprepared for is escrow. During escrow real estate transactions, funds are stored in escrow, secured by a neutral third party. 

In this article, we’ll help you understand how escrow holders manage funds until conditions are met for release, protecting both parties. We’ll also discuss per diem, a penalty for closing delays between the loan closing date and the start of the repayment period. 

With this knowledge, we hope you can navigate real estate deals confidently, mitigate risks, and streamline future negotiations. 

Escrow: Definition and Importance 

When investors engage in real estate transactions, the property, title, earnest money, etc. are stored in escrow while the sale is pending. Escrow refers to a legal holding account in which items are stored by a neutral third party, usually a lawyer or escrow officer, who safeguards the items until certain predetermined conditions are met.  

The purpose of escrow is to assure all involved parties that the conditions and responsibilities outlined in the escrow agreement are fulfilled before property changes hands. In real estate transactions, these conditions include a series of steps including the appraisal, home inspection, financing, insurance, title search, zoning, and any negotiated repairs. 

Escrow protects both buyer and seller, reducing the risk of fraud since assets are held by a neutral party. When all conditions are met, the property or funds in escrow will be released to the proper parties. 

Escrow Agents 

Escrow agents, or escrow holders, are neutral third parties (usually attorneys, bank representatives, or real estate title businesses) who hold assets on behalf of the buyer and seller in a transaction. It’s the job of an escrow agent to facilitate the transaction and ensure that both parties fulfill their contractual obligations as per the purchase agreement. Escrow agents have a fiduciary responsibility to both parties and should be unaffiliated with them in order to best uphold their duties. 

Escrow Types 

Real estate escrow is the most common type of escrow. In real estate escrow, the property, title, and cash involved in the sale are kept in escrow while the sale finalizes. 

Within real estate, there are several more types of escrow accounts. They include: 

  • Real estate sales escrow accounts – This is the most common type. Once a purchase contract is signed, the buyer deposits escrow money into an account, where the funds are kept until the seller transfers the property title. Once the title is transferred, the escrow funds are released to the seller. 
  • Independent home sellers/buyers – Sellers can also list their homes with an escrow service. When they find a buyer, they give this person’s information to the escrow service, which works with the buyer to facilitate the transaction. 
  • Mortgage escrow – Mortgages are commonly paid through escrow accounts. Borrowers will make monthly payments into an escrow account, which the lender then uses to cover property taxes and insurance on their behalf. 
  • Construction escrow – Construction escrow accounts are for funds used during new construction.  

However, escrow is also used for other purposes. There are many types of escrow accounts that assist the sales process for a variety of assets. For instance, escrow is used in internet transactions (e.g., cryptocurrency exchanges), company sales, car sales, and more. Each type serves different purposes and industries, providing security and reducing risks for transactions. 

Escrow Process 

The real estate escrow process begins when a seller accepts an offer to buy the home and ends when a new deed is created in the buyer’s name and all funds have been distributed to the appropriate parties. Escrow has several defined stages, where parties need to take specific steps to advance.  

  1. Escrow account is opened

Escrow is initiated when the buyer and seller agree on a price for the home and enter into mutual agreement. At this point, a home purchase contract is drafted and signed by both parties. Then, your agent will collect a good faith deposit (sometimes called earnest money) to place in escrow. 

  1. Lender appraisal

After the escrow process has begun, the buyer’s lender will typically require their own appraisal of the property. This is paid for by the buyer and used to ensure that the property appraises for at least the purchase price. If it doesn’t, you likely won’t be able to secure financing unless the price is negotiated down. If an appraisal contingency was included in the purchase contract, the buyer will have more options to either negotiate or back out of the transaction. 

  1. Loan finalization

If the home appraises for its purchase price, your lender will finish preparing your loan. Details like the loan amount, monthly mortgage payment, interest rate, and any closing costs and underwriting fees will be detailed. If you’re required to purchase private mortgage insurance (PMI), that may be included as well. 

If the buyer can’t secure financing for some reason, they may fall back on a financing contingency (again, if one was included in the contract). This contingency usually states that the buyer can back out if they are unable to secure a loan for the property. 

  1. Seller disclosures

In this stage, the seller must disclose any known problems with the property, such as needed repairs, pest infestations, housing code issues, etc. These are called seller disclosures and are usually prepared in written form for the buyer if not already disclosed. The buyer must approve of these disclosures and acknowledge that they’re aware of them before moving forward. 

  1. Home inspection and insurance

Next, a professional home inspection should be conducted. This may include inspections for pests, environmental hazards, infrastructural issues, and other issues. If major issues are uncovered during the inspections that weren’t included in the seller disclosures, the buyer may want to back out of the deal. They might be able to do so or negotiate the price lower if they’ve included a home inspection contingency in the purchase contract. 

Buyers will also need to purchase homeowner’s insurance premiums. Sometimes flood insurance, earthquake insurance, or other insurance is also necessary depending on the location and region of the property. Lenders require homeowners’ insurance, but it’s also a vital source of protection for the buyer as they begin making mortgage payments and building equity in the home. 

  1. Property title search

A property title search looks for the home to have “clear title,” or no existing liens against it. A title report can be obtained through a title company (this could be the same as your escrow company), which verifies that the seller truly does own the property and can therefore legally transfer the title and deed to the new buyer. Defects in the title will need to be fixed before the transaction continues. 

Lenders also require a property title search, but this is again a crucial step in protecting buyers legally. If a problem with the title is discovered later, legal issues could become even more complex.  

  1. Final walk-through

Most buyers perform a final walk-through to ensure everything looks good and as expected. This is also a good time to double check for appliances or permanent fixtures and ensure both parties are clear on whether they will stay in the home as part of its cost or if the seller will take them. 

  1. Close on the home

The closing process can be complex. Typically, the buyer will receive a Closing Disclosure (CD) listing the closing costs and loan details at least a few days before the date of the closing appointment. The buyer must review and sign this document and any others their agent provides before attending the appointment.  

After all the paperwork has been signed at the closing appointment, the escrow officer is responsible for preparing a new deed for the property, in the new buyer’s name. The old deed is then voided, and the title will be transferred to the new buyer. Sometimes, the escrow officer will need to file the new deed with the county recorder so the purchase is officially recorded before the new buyer can receive the keys. 

Remaining amounts due (such as the remainder of the down payment and closing costs) will then be transferred to escrow via wire transfer. From escrow, the funds can then be transferred to the seller. 

Mortgage Escrow Accounts 

Mortgage escrow accounts are a second type of escrow that is often used after a buyer has purchased a home. These accounts are typically set up by mortgage lenders, and they are used to store funds for certain expenses that your mortgage lender will pay on your behalf, such as property tax payments and insurance payments. 

If you have a mortgage escrow account set up on your behalf after the sale, be sure you understand how it works and ask your lender if you have any questions. 

Benefits of Using Escrow 

Escrow accounts are often required for government-based loans and usually mandatory if the down payment is less than 20%. 

However, there are many other benefits of using escrow to facilitate the transfer of funds during a real estate transaction. As a real estate investor, you can benefit significantly from using escrow due to its ability to provide security and minimize transaction risks. Escrow ensures that funds or assets are safely held until all conditions are met, reducing the chances of fraud and ensuring compliance with agreed-upon terms. 

By utilizing escrow, you can facilitate complex deals more efficiently, build trust among involved parties, and have a secure payment method in place. This process not only safeguards your interests but also streamlines transactions by offering a structured and protected way to handle payments and finalizations. 

Understanding Per Diem in Real Estate 

Per diem, derived from Latin for ‘for each day’, refers to daily interest charged on loans like mortgages. Per diem interest typically applies during the period between the closing date of the loan and the day the loan period commences. Because not all loans begin on the same day that the home is closed on, lenders charge per diem rates to cover the intermediary period. 

Per diem rates charged by lenders most commonly appear on the Closing Disclosure (CD). 

Per diem rates can also apply to other parties and in other circumstances. For instance, sellers can charge buyers per diem interest if the sale does not close by the expected date. Listing agents can include per diem clauses, especially for vacant properties, to cover ongoing expenses in case the buyer does not close on the home by the planned date. Buyers can also request per diem rates for delays caused by sellers or changes to original offers. This practice encourages timely deal completion, protects sellers from additional costs, compensates for delays, and maintains accountability. 

Purpose and Benefits of Per Diem 

No one wants a delay in the sales process. But sometimes unexpected problems occur—the appraisal might be low, damage might be found during the home inspection, or the buyer may have more difficulty securing funding than they anticipated.  

Because buyers can also ask for per diem if the seller causes delays, per diem offers flexibility in negotiating terms and managing costs for both parties, making it a valuable tool in real estate transactions. It is useful for vacant listings incurring ongoing expenses, buyer- or seller-initiated changes to the original offer, extensions of contingency periods during escrow, or other delays caused by one party leading to additional costs. Implementing per diem clauses in agreements streamlines transactions, manages delays efficiently, and supports negotiation flexibility. 

Conclusion 

As a real estate investor, understanding escrow, escrow holders, and per diem is essential for ensuring secure transactions and protecting your interests. Both escrow and per diem help facilitate a standard and fair process for navigating the complex task that is transferring ownership of a large and complex asset like a home. 

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