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What Are Escrow and Underwriting?

by Chelsea Lothrop, studioD

Lenders take on a large financial risk when they approve a homeowner's loan. If the homeowner defaults on the loan or is forced to short sell, the lender or bank loses some of the money it is owed. In order to prevent this from happening, lenders take preventative measures to reduce the risk of financial loss. Two such measures are real estate escrow and underwriting.

Escrow Defined

Escrow is a deposit of funds placed in the possession of a neutral third party until certain conditions are met. An escrow holder collects all of the funds and documentation associated with a real estate transaction. This ensures that all of the contingencies upon which the sale is based are met before the title and funds are transferred and the escrow is closed.

The Escrow Process

The principals involved in the transaction, which may be seller and buyer or lender and borrower, submit a signed purchase agreement and escrow instructions to their escrow company, which is chosen according to a mutual agreement between the parties. The escrow instructions are compiled and agreed upon by the principals involved. These instructions explicitly state what terms and conditions must be met before the escrow may be closed. The escrow holder will follow these instructions to process the escrow. Once all of the required elements in the instructions are met, the escrow will be closed.

Escrow Accounts

A special type of escrow account may be set up by a lender following the completion of a real estate transaction. This account is used to collect escrow funds as a part of the buyer's monthly mortgage payment. These funds are used to pay real estate taxes and insurance premiums as a way of ensuring the lender that these taxes and fees will always be paid in full and on time. At least once a year, the lender must provide you with a statement itemizing what percentage of your monthly payment is being placed into the escrow account and the total amount put into the escrow account during the period. The statement will also list the amount that was paid out for taxes and premiums, followed by the escrow account's remaining balance. Not all lenders require such an escrow account. Before you secure financing, check with your lender to determine whether it will require one.

Underwriting Defined

Underwriting is the process a lender uses to determine whether to accept or deny a loan applicant. This decision is based upon income, amount of debt, debt-to-income ratios, credit history, and savings. An underwriter's job is to verify all of the information provided in your loan package and to ensure that it meets the particular loan's guidelines. He may also evaluate the home's appraisal to ensure that it is thorough and accurate. No loan application can be accepted without the approval of an underwriter.

Automated vs. Manual Underwriting

Most underwriting today is done through an automated underwriting system, called AUS. An underwriter will review the appraisal and other related documentation, but the computer formulates an approval or denial based on the input data. If an AUS denies an application, the application may be eligible for manual underwriting. The benefit of manual underwriting is that it allows for consideration of factors not considered by an AUS. Certain factors that are cause for automatic denial in an AUS, such as a prior short sale or foreclosure, may be mitigated by other circumstances that can only be assessed through manual underwriting.

About the Author

Based in Connecticut, Chelsea Lothrop has been writing for publication since 2009. Her primary focuses are real estate, personal health, and literature. Lothrop is a former contributor to the Speedy Tenants Rental Agency blog. She is currently completing her bachelor's degree in literature through Arizona State University.

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