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What is a Payment in Escrow and How Does it Work?

If you’ve ever bought a house then you’ve more than likely heard the phrase “payment in escrow,” but it’s a term that has ramifications far beyond the real estate sector. In essence, an escrow is a type of legal holding account for funds or assets, which won’t be released until certain conditions are met. The escrow is held by a neutral third party, which releases it either when those predetermined contractual obligations are fulfilled or an appropriate instruction is received.

Escrow is effectively used as a middle ground until both parties are satisfied and a transaction can go ahead – it is a vital failsafe for both parties. In a B2B context, it makes a lot of sense, as it ensures both businesses are satisfied with a large transaction before the trigger can be pulled and the funds or assets can be transferred.

What is an escrow account?

Quite simply, an escrow account is an account in which the third party holds the escrow funds or assets until the obligations of both parties have been met. They are most commonly used in the housing market to make monthly payments on a mortgage, with expenses such as insurance and taxes (as well as annual expenses) often also baked into this monthly payment. 

This exists because the lender (the bank, in this case) can’t be 100% sure that the homeowner will be able to pay their mortgage every month. They use an escrow account to mitigate the risk. In online transactions, meanwhile, escrow is rarely used on a rolling basis, but as a one-off transaction, with the escrow account holder supervising every stage of the process.

How does escrow work?

In any situation where there is uncertainty over a transaction between both parties, escrow serves as a necessary mediator and holding ground for the funds or assets involved in that transaction. Escrow is used most commonly in real estate, but is also used in many other contexts where there are a lot of funds, intellectual property, or assets at stake, and that includes mergers and acquisitions.

To use a typical example, take a startup business that wishes to sell its goods or services to another business in another country. The business doing the selling is going to want some assurance it will get paid when the goods or services are delivered and the business doing the buying is going to want to assure the goods arrive in the agreed-upon condition, or the service is delivered to the agreed-upon level of satisfaction. If the buyer places the payment in escrow, both parties are covered until both parties are satisfied.

Escrow conditions

There are several conditions that might need to be met before escrow is released. At the most basic level, the buyer must supply the payment and the seller must supply the product or service. But there are often more complicated conditions to negotiate.

For example, the buyer might wish to inspect the purchase before releasing funds, or the seller might need some proof of payment. Particular complications can arise in situations where one party has a reason to feel unsure of the other party – in such case, it’s up to the escrow provider to act as a mediator of sorts. That’s why it’s always wise to use a trusted and respected escrow provider with a proven track record.

Escrow in the stock market

While everyone is aware of escrow use in the real estate market, it’s also commonly used in the stock market, with stocks often issued in escrow. This is often done tactically so that those who are issued stocks as a bonus can only sell their stocks when certain conditions have been met.

Online escrow payment

In any online sale, there is an element of risk, especially when the seller is located in another country or even continent. In a B2B transaction, there are further complications to consider, as taking legal action against another business is always going to be intimidating and potentially costly.

Ways around this issue include trading solely on respected online marketplaces such as eBay and Amazon, or making use of the consumer protection features of your credit card. For larger transactions, however, escrow is the only option that makes sense. It allows the buyer and seller to set out their terms and the third party can store funds in an escrow account while the particulars are being ironed out.

Why use escrow?

Ultimately, escrow is a means of shielding your transaction and ensuring that fraud isn’t allowed to happen. It does mean putting your fate in the hands of somebody else, of course. But as long as it’s somebody you trust, you could also see it as a way of letting them take care of the logistics so you can spend more time focusing on what really matters.

We can help

If you’re interested in the possibilities of a cardless escrow account and would like to find out more then get in touch with the financial experts at GOCardless. Visit our website today to find out how GOCardless can help you with ad hoc payments or recurring payments.

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