Escrow Payment Definition
Escrow payment is a legal concept involving a financial arrangement between three parties whereby a third party agrees to hold an asset or money on behalf of the other two involved in a particular transaction at a given time. For this arrangement, an escrow charges a certain sum of money as commission or fees and keeps the transaction secure by managing and fulfilling predetermined contractual obligations.
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Types of Escrow Payment
There are seven types, which are as follows.
- Internet Escrow – Under this arrangement, a licensed independent third party agrees to keep the money to safeguard the interest of both buyer and seller.
- Banking – Under this arrangement, a machine is used which holds money—for example, ATMs and vending machines, etc.
- Intellectual Property – Under this escrow arrangement, the third party holds the source code for safeguarding the interest of both customers and suppliers.
- Law Escrow – This arrangement is used to distribute funds from an announced cash settlement in an environmental enforcement action or class action suit.
- Real Estate Agreement – This escrow payment arrangement is used to pay for real estate properties and hazard insuranceHazard InsuranceHazard Insurance is kind of property insurance which gives coverage of the protection to property owners from damage to property caused by natural calamities like fire, flood, cyclone, storms and other natural events and according to this policy, the property owner will get the compensation to cover the cost of damage to property due to natural calamities where the premium for this policy depends upon the cost of property and risk covered..
- Merger & Acquisitions – Under this escrow payment arrangement, warranties and indemnities are offered by selling parties, usually used when the seller’s credit riskthe seller's credit riskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. is not of good quality.
- Gambling – Under this type of escrow arrangement, parties who have gambled on a particular event hand money to a neutral third party who makes payment after the event as per the fixed terms and conditions.
Examples of Escrow Payment
Here we can see some examples.
Imagine a person owes $3000 per year in property tax and $1800 for insurance premiums. To get the monthly escrow payment amount, we need to add this tax and premium expense and divide the result by 12.
Monthly Escrow Payment = ($3000 +$1800) / 12 = $400
Imagine a two-person entering into an arrangement with a third-person involving gambling escrow payment whereby the first two-person bets on winning two different out of ten horses running in a horse race. If either of both the horse wins the race, the escrow agent, i.e., the third person who has been handed over possession of money, will make payment to one of the people whose horse wins the race; otherwise, the money will be returned as it is after the deduction of escrow commission.
Therefore, as per the above terms and conditions, the third person will hand over the money to the owner , else will return it after completing a horse race. The escrow agent will earn a commission in either of the cases.
Some of the advantages are as follows:
- Under an escrow payment arrangement, both buyers and sellers ensure hassle-free transactions.
- The escrow agent independently verifies the article or service provided before the occurrence of a transaction.
- Two parties involved in the transaction get rid of paperwork and have to just make the deal without wasting their time.
- The cost of arranging escrow payment is low, as the fees charged by the escrow agentEscrow AgentAn escrow agent is an individual or a company that is probably better termed as a trusted third-party that holds a document or an asset for the first party to deliver to the beneficiary or second party as the event mentioned in the escrow agreement takes place. are very nominal.
- With the help of an escrow accountEscrow AccountThe escrow account is a temporary account held by a third party on behalf of two parties in a transaction. It reduces the risk of failing to oblige the transaction by either of the parties. It operates until a transaction is completed and all the conditions are met., taxes and insurance premiums can be paid in monthly installments instead of onetime processing payment.
- It is also useful from a credit rating point of view, which further helps get loans at lower interest rates from banks
Some of the disadvantages are as follows:
- This type of arrangement requires the maintenance of significant monthly funds.
- Organizations with fluctuating incomes may face a problem when they are short of funds.
- Money deposited in the escrow account gets locked, i.e., one does not have control over the money anymore.
- The money deposited in the escrow account cannot be withdrawn even when there is an emergency.
- This arrangement leads to a loss of interest on money kept invested in it. Although some escrow arrangements do provide interest, it is very minimal.
- With the changing technology, specific changes are taking place in escrow payment arrangements. One of the most critical changes in internet escrow under which a third party (the escrow agent) keeps the money to ensure the safeguarding of interest of both buyer and seller.
- Another recent change in escrow payment transactions is the involvement of interest factors. Earlier, escrow agents didn’t provide interest on funds in possession, but now the concept is changing. Escrow agents have started providing interest on finds in their possession.
- Innovations in types of escrow arrangements: As mentioned and explained above, now there are multiple types of escrow payments being arranged, and hence one may use them as per their requirements.
- With the increasing use of this arrangement, law and regulatory authorities are also focussing on developing rules and regulations for escrow payments to ensure the smoothness of transactions.
It is a contractual arrangement between three parties whereby the third party agrees to keep money on behalf of the other two and make payments per the contractual terms and conditions. Additional escrow payments like real estate, internet, law, intellectual, merger and acquisitionMerger And AcquisitionMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion., gambling, etc.
Escrow payment transactions help ensure the security of transactions occurring as per terms and conditions. The cost of an escrow arrangement may not be feasible at times. With the changing business models, specific changes are occurring in escrow payments. Due to increased volume and ensuring monitoring of transactions, there are legal rules and regulations in the course of development.
This has been a guide to Escrow Payment and its definition. Here we discuss types and examples of Escrow Payment and its advantages and disadvantages. You can learn more about financing from the following articles –