What is an escrow account and how does it work?

Buying a house is the largest financial transaction most of us will ever make. So it's fairly common for a trusted third party to hold onto the money while the deal is completed or other conditions are met, protecting both the buyer and seller from nonpayment or fraud.

You may have heard of this legal arrangement as being "in escrow."

While an escrow account can be used in other situations — online sales, legal settlements and the stock market, for example — it's most commonly associated with home buying and ownership.

CNBC Select looks at what real estate escrow is, how it's calculated and the advantages and drawbacks of .

• What is an escrow account?
• How is escrow calculated?
• Who manages escrow services?
• Pros and cons of an escrow account
• Bottom line

The funds in an escrow account are held by a third party until the transaction is complete. In the world of real estate, there are two main types of escrow.

Homebuyers escrow

Buyers are often asked to put a deposit down to show their interest is legitimate, especially if the down payment is less than 20% of the total purchase price. To protect both them and the seller, that deposit is put into an escrow account until the sale is completed. If the seller stops the sale, the funds in escrow are returned to the buyer. If the deal is interrupted because of the buyer, though, the seller typically keeps the money.

When the purchase is completed, the funds in the escrow account are typically applied toward the down payment.

Mortgage escrow

After you've purchased a home, your lender will likely require an escrow account for you to deposit your monthly mortgage, insurance and property tax payments, especially if your down payment was less than 20%.

A Chase Bank mortgage is a great option for borrowers looking for a smaller down payment. Chase's DreaMaker home loan allows buyers to put down as little as 3% of the home's price.

CNBC Select also recommends Ally Bank Mortgage: In addition to a low down payment, Ally waives origination fees and offers fixed-rate and adjustable-rate mortgages, as well as 15-year, 20-year and 30-year loan terms.

Escrow for homebuyers is typically 1% to 3% of the total cost of the property. Mortgage escrow is usually determined by the lender, who estimates your property taxes, insurance payments and other expenses for the next year and divides the total by 12.

This amount is typically added to your mortgage, so you just have one simple payment to track.

When a seller accepts a bid, the buyer's good-faith deposit is put into an account that may managed be by an escrow agent, title company or mortgage servicing company. Typically, that company is paid a fee.

For homeowners, mortgage escrow accounts are typically managed by the lender, who has a vested interest in making sure they pay their bills on time.

Using an escrow account can provide peace of mind to all parties involved in a home sale.

For homebuyers: Escrow protects your deposit by putting it in the hands of a third party for safekeeping. If it was with the seller, there could be problems getting it back if the sale fell through.

For homeowners: You don't have to keep track of monthly property tax and insurance payments as they're automatically paid on time. In addition, you can avoid facing an enormous tax bill you've been contributing incrementally.

For lenders: Using an escrow account to cover mortgage, insurance and tax payments can help prevent foreclosure and ensure insurance is available in the event of an accident or natural disaster.

While escrow does provide a lot of benefits, there are some downsides.

Loss of investment opportunities: In addition to your mortgage, you're also paying a chunk of your property tax bill and insurance premiums into the account — money that can't be earning a higher return elsewhere.

High upfront costs: Many escrow accounts require a minimum balance to cover unexpected expenses. You may have to keep an extra two or three months' worth of property taxes and insurance premiums as a cushion, or "escrow reserve."

It's only an estimate: Your monthly payments are typically based on last year's bills, but that's only an estimate. If your property taxes went down, you've actually been tying up more money than you needed to.

While escrow accounts can be used in different fields, in the homebuying process it is used to protect the buyer's deposit until the deal is complete. At that point, it's usually put toward the down payment.

An escrow account can also be used to ensure that mortgage, insurance and tax payments are made promptly.

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