Construction Escrow: What Is it? Who Does it Benefit? And Other Questions Answered
Contractors and suppliers often come across escrow accounts. Why is it necessary to have a third party institution manage funds for a project?
Having money in escrow can mean your payment may be delayed, but you’re guaranteed to be paid, eventually.
Here we will go into what an escrow account does and which parties benefit from it.
Payments From Construction Escrow Accounts May Be Slow – Don’t Delay Further With Incomplete Pay Apps
Flexbase helps manage your cash flow so you can focus on growing your construction business. We can send your construction invoice and paperwork to your customers quickly and accurately. By using Flexbase, you can get paid faster and be cash flow positive.
Flexbase automates paperwork and compliance with each state where the project is completed. Quickly generate payment apps with …
- AIA forms
- Schedule of values
- Lien waivers
- Notarizations
- Prevailing wage
- Insurance documents
… and more in as little as two minutes.
We make sure all the documents requested by an escrow account are included in your pay apps.
What Is Construction Escrow?
Construction escrow is a third party holding account for funds on a construction project. This account holds funds for the project until specific terms are met, then releases those funds to the contractor. Having funds in escrow helps guarantee that funds will be available for the project.
The financing company, the title company or project owner, or even the contractor may request an escrow account. This account is funded before the work begins based on the projected budget for the project.
What are Escrow Accounts?
Escrow accounts can be used for any construction project.
Escrow services are more often found on financed projects, but there is no limitation to when an escrow account can be used. They are often used when a lender is financing a construction project and deposits escrow funds with a title company.
An escrow account is set up when the construction loan closes. This happens preferably before the construction starts.
These accounts are also often used in new construction.
For example, when building a new home, the lending institution will often use a construction escrow account. When the project is completed and passes inspection, the funds will be released to the contractor.
Who Manages Construction Escrow Accounts?
In some states, contractor escrow services are handled by a licensed title insurance company or an escrow company. In other states, an attorney handles the transaction.
In many states, escrow agents must be properly licensed in order to conduct business. The escrow agent must be an unbiased third party or one who is not otherwise associated with the transaction.
How and When Are Payments Distributed From Escrow Accounts?
It’s the title owner’s responsibility to put money into an escrow account.
However, funds can be requested by the project owner or the contractor. The escrow account is then accessed by the third party that controls the account.
When the contractor is ready to receive funds for completed work, they submit a pay application or request a “draw” from the escrow company.
Upon approval of each building phase, the contractor can request a draw of funds to pay off building costs such as:
- Contractor bids
- Excavation costs; and
- Permit fees
This request is reviewed by the escrow company for the bank. Then, an onsite inspection may happen to ensure the amount requested matches the work completed.
Sometimes these funds are held back until the work is completed.
It’s common for builders to agree to a certain closing date, but circumstances delay finishing the work.
Escrow holdback for new construction is when money is set aside in an escrow account until the home or building is built. This holdback acts as an incentive for the contractor to finish the work and ensures the contractor will be paid once the work is complete.
Escrow holdback is also frequently used for home repairs on existing dwellings. Payments are held in escrow until the repairs are completed. A resident may sometimes be permitted to live in the home while the repairs are made with a permit.
What Are the Benefits of a Construction Escrow Account?
The Benefit of an Escrow Account – For Contractors
When working on a project with an escrow account, you’re less likely to feel the uncertainty that the contractor will be funded.
While there are some responsibilities on the contractor’s and builder’s end, such as submitting the appropriate paperwork and ensuring the payment requested matches the work completed, having funds in escrow to pay for the work allows the contractors to better focus on the job at hand.
The Benefit of an Escrow Account – For Owners
Though the contractor, lender, and the buyer are all protected by escrow, the buyer, or the owner, receives the most protection:
- This provides a legal safety net from non-project creditors.
- The owner no longer has to worry about paying the property taxes or insurance on time.
- The owner can rest easier knowing the contractors will be paid without the need to do much legwork.
However, an escrow account is beneficial for the owners only when that account is properly funded.
Here’s a simple example of why.
Escrow on new construction is common and easy to understand from the property owner’s perspective.
When an owner buys a piece of property, the taxes are not finalized yet. They are paying taxes based on the land value.
After a new house is built, the taxes go up because the property value has gone up. With a properly funded escrow, taxes on new construction are no longer the owner’s sole concern. Those managing the escrow account make sure insurance and taxes on that property are paid in full and on time.
It’s important for all parties to communicate, and the owner of the property counseled, to make sure that the escrow account will be funded based on the current value of the property. Funding an escrow account based on the land value may mean that the owner has a cash flow problem coming in the future.
The Benefit of an Escrow Account – For Lenders
For lenders, an escrow service means that the lender doesn’t have to do a lot of the groundwork to make sure contractors are paid.
Is There a Downside to Working on a Project With a Construction Security Escrow Account?
The primary downside to a construction escrow account is that because payments are funneled through a third party, these payments take longer to process. This means it takes longer for contractors to receive this payment.
4 Factors for Contractors to Keep in Mind Regarding Construction Escrow
#1: Managers of Construction Escrow Accounts May Require You to Submit Extra Documentation
The escrow account manager tries to ensure that the account is only used for completed work. Projects that are partly completed are not meant to access the funds in escrow. Because of this, the escrow account manager has higher documentation requirements.
A contractor may need to submit proof of costs and completed work. Then, an inspector may need to be sent to verify the work has been completed.
Flexbase is built to help keep track of all the documentation required to manage escrow for contractors.
Once Flexbase is aware of all the documents required for each pay app, we will ensure that you don’t miss any of the documentation.
#2: You Have the Right to Request the Use of a Construction Escrow Account
A general contractor can ask their customers to set up an escrow account for any project. It does not have to be in conjunction with any other financing activity or construction loan.
If you question the financial status of the project owner, using an escrow account on a large project ensures that funds are available before the work begins.
Suppliers and subcontractors may find an escrow account a cumbersome process to access. If the subcontract is large enough, the cost for managing the account may just be worth it.
#3: Contractors May Not Even Know That a Construction Escrow Account Is Being Utilized
Lower-tier contractors or suppliers may not be aware that an escrow account is being used for the project. The flow of money on a construction project isn’t usually impacted either way.
#4: Construction Security Escrow Accounts Typically Mean You WILL Get Paid – Eventually
An escrow account means more security. You will eventually get paid for completed work.
In the meantime, managing your cash flow well can keep you from getting into trouble.
By using Flexbase, you can borrow capital to help your cash flow instantly. Flexbase uses your payments data to give you the best rates from our lending partners. You don’t have to put together paperwork for tedious bank visits and negotiations.
Optimize Your Cash Flow on Escrow Projects With Flexbase
Waiting for payment from an escrow account can make managing cash flow even more important.
In the interim, Flexbase can give you immediate access to working capital. We do the work for you to find out what you’re qualified for and give you a list of lending institutions and options to choose from.
