Financial dealings are fraught with uncertainty. Escrow accounts and performance bonds are two ways of lessening that uncertainty by enlisting third parties to help guarantee that money will be available when it’s needed. Performance bonds and escrow accounts try to lessen the chances of an unscrupulous person absconding with your funds or taking money intended for a specific purpose, such as building a house or paying taxes, and skipping town with it. While both escrow accounts and performance bonds offer financial security to both parties involved in a contract or financial relationship, the two types of guarantees aren’t interchangeable.
Escrow in Real Estate
You may be familiar with escrow accounts in connection with your home mortgage. Your mortgage company collects money each month in addition to the amounts you owe on the principal and interest for your mortgage and puts these funds in an escrow account, then uses money from the escrow account to pay your property taxes and homeowner’s insurance each year. Another use of escrow accounts in real estate transactions occurs when you put a down payment on a house at the time you make an offer for the house. The real estate agent handling the sale puts the down payment funds in an escrow account, where they are held until the time of closing. The escrow account is in the hands of a third party, keeping it separate from other funds and holding it safely for the home seller and buyer. When you build a house, you’ll open an escrow account where you deposit cash or money from financing and disperse the money to the builder as stages of the house are completed.
Other Uses of Escrow
Other businesses use escrow accounts, too. Entertainment agents puts funds they receive on behalf of their clients in escrow accounts until the agent disperses the funds to the client. After the BP oil spill in the Gulf of Mexico in 2010, BP set up an escrow account to distribute money to individuals and businesses who had suffered losses due to the spill. Anytime a third party receives money to hold on behalf of two other parties until the money is dispersed, escrow is established. The third party is unrelated to either of the two parties and must remain neutral in any dispute between the two sides.
Performance bonds, also known as surety bonds, are a type of insurance that protects one party in a contract if the other party in the contract fails to meet his obligations. The party who is supposed to perform a service or complete a task, such as a contractor who is supposed to build a bridge, buys a performance bond from an insurance company. The size of the performance bond is usually designated in the contract. If the contractor fails to complete the bridge, the other party in the contract receives the money in the performance bond, which should be enough money to complete the project. When cities, states and other government entities enter into construction contracts for roads, bridges, stadiums and other large projects, they usually require the contractor to purchase a performance bond. This protects the government agency from loss if the contractor fails to complete the project.
When two parties establish an escrow account, they expect the money in the account to be distributed or used to pay bills at some point. When a contractor takes out a performance bond, both parties to the contract hope the bond will never have to be used, since doing so means the contractor failed to meet his obligations. Performance bonds are most commonly used with large industrial contracts, while escrow accounts play a part in many everyday real estate transactions and other small business relationships. One party in a contract pays a fee for a performance bond – usually a percentage of the cost of the entire job, while the cost of setting up an escrow is absorbed as part of overhead for the real estate agent, entertainment agent or party in a lawsuit and often isn’t itemized or broken out as a separate fee in the overall transaction.