What is an Escrow Account?
An escrow arrangement safeguards the seller against any risk of payment default by the buyer as it removes the control of cash flow from the buyer to an independent party.
Related: Short term investment options for high returns
The term “escrow” originates from the French term “escroue” which means a scrap of paper signifying a deed that is held by a third party. In simple language, the escrow account can be regarded as a third-party account. It can be a bank account where the asset value is held until the fulfilment of specific conditions of the transaction. An escrow arrangement safeguards the seller against any risk of payment default by the buyer as it removes the control of cash flow from the buyer to an independent party. The holder of the escrow account makes sure that the amount is released on the fulfilment of specified conditions. Let us take an example. If you are selling your product in the overseas market, you need to have the assurance that you will receive the payment when your buyer receives your goods. Similarly, the buyer would want to release the payment only when he or she is assured that the goods are certain to reach the port of destination. An escrow account satisfies both these expectations and offers the safety that is required to go ahead with the transaction.
Thus in a transaction where escrow account is used, the following activities take place,
- The buyer and the seller agrees on the terms and conditions
- The buyer pays the amount into the escrow account
- The seller performs the service/ships the goods
- The buyer receives the same
- The escrow releases the amount in favour of the buyer
Related: 6 Practical strategies to help reduce investment risk
Range of transaction it covers
- In Project financing transactions, third-party escrow is used to cover the performance guarantee through special purpose accounts. These are long-term infrastructure, industrial or public service projects where the arrangement could be to payback from the cash flow once the project is operational. Thus these escrows are in the nature of loan repayments.
- Real estate industry uses escrow accounts effectively as it allows the buyer to carry out adequate due diligence of any potential purchase. It also assures the seller that the buyer is capable of paying up the required amount and reiterates the seller’s seriousness. Escrow can be used not only for the purchase price but also for monthly payments to be made against the property mortgage.
- Escrows can be used in case of shares as well. Escrow shares are those which, although allotted to a particular shareholder, cannot be traded as these are held in escrow for a specific period. Escrow shares are used in case of a merger and acquisition scenario or while awarding stock bonuses to employees.
Related: Important things to know before investing in the stock market
- Online transactions are an ideal platform for using escrow accounts. It is often deemed risky to buy items online, particularly if the items are expensive. For example, if you are buying an expensive work of art, you may insist on holding the money demanded on escrow until you receive the artwork and are satisfied with its authenticity.
- Public issuances made by companies require escrow services, as do share buybacks. Banks offering escrow services provide end-to-end solutions starting from application to allotment of shares and subsequent refunds, if applicable.
- Normal sale and purchase transactions can call upon the services of an escrow account if the buyer and the seller identify a need for independent oversight of the payment transaction.
Related: Ever heard of loans that help you save money?
In order to open an Escrow Account, both the client and beneficiary should collectively submit a Request/Application Letter. The purpose and the terms of the transaction and the escrow will be mentioned in this request letter. The role of the bank is expressly laid out, and so is the fee to be charged by the bank for the escrow service. The latter can be in the form of account opening fee and annual fee. The escrow agent is the neutral entity who coordinates between the parties and also carries out the process of dispute resolution if required. In case of rejection of goods or services, for example, both parties may be given a time period for arbitration, after which the payment is released by the escrow agent as per the outcome of the dispute resolution.
Have a look at the 5 Ways to start investments even if you don't have money right now to understand how investments can lead to equity enabling escrows.