What is Earnest Money?
When you have found your dream home and had your offer accepted by the seller, they will take their home off the market. In this situation, the seller is taking a risk by removing their home from the market. They will lose out if you don’t move forward with your offer and buy their home.
To balance this situation, they normally ask for a deposit as a show of good faith. This deposit is commonly known as earnest money.
But what is earnest money, and what should you know about it before you make an offer for a home?
We look at earnest money and what you can do to avoid things going wrong when buying a home.
What is Earnest Money?
While you might know that you are serious about buying the home you have made an offer on, the seller doesn’t know this. But as they say, money talks, and putting down a deposit of a few percent of the purchase price demonstrates how serious you are.
Without the requirement to pay earnest money when making an offer on a home, buyers could make multiple offers on different properties. This could give them a better chance of buying a home in difficult market conditions, and there wouldn’t be any downsides for them. They could walk away from purchases leaving the sellers high and dry, needing to start looking for a new buyer again.
Instead, with a deposit paid into escrow, the money could go to the seller if the sale doesn’t close. If the buyer backs out without good reason, they will lose their deposit.
In a sellers’ market, where many buyers are competing against one another, the size of the earnest money could become the deciding factor that sets you apart from other buyers. Offering more as an earnest money deposit could even sometimes get you better purchase terms with the seller.
If there are more homes for sale in the area than people looking to buy, it is a buyers’ market. In these situations, the buyer has more power and they can offer less earnest money. There will be less chance that other buyers will come along, making competing offers for the home. This gives you more room to negotiate a better deal and add more contingencies to the purchase contract.
Do You Need an Earnest Money Deposit When Buying a Home?
While earnest money isn’t an absolute requirement, it is normally expected. If you are serious about buying a home, the earnest money is essential.
The deposit shows that you are seriously committed to buying the home as you have put your money on the line. This makes taking the home off the market less risky for the seller, while inspections and appraisals are completed.
How Much Earnest Money Should Be Offered?
There isn’t normally any set amount, and it can be 1%, 2%, or even 5% of the purchase price. And in sellers’ markets, the earnest money can be higher still. In particularly competitive markets, earnest money deposits of 10% are not unheard of.
If you have made an offer of $300,000 for a home, the earnest money deposit could be between $3,000 and $15,000 typically.
While there are no set rules for how much earnest money you have to pay, the majority of sellers are not going to take your offer seriously without a deposit close to what other buyers are offering.
When buyers are competing for a home, a larger deposit might make your offer seem more attractive. Even if you do pay a larger deposit, most of the time, you are going to get this money back at closing which can contribute towards your down payment and closing costs.
Paying the Deposit
It is normal to provide a copy of the buyer’s earnest money check when making an offer to the seller. This should give the seller more confidence in your offer, showing that you’re willing to back up your bid with earnest money.
However, you do not simply give this check to the seller. Instead, the check needs to be put in an escrow account or given to a third party that you can trust. This third party could be a title company, real estate broker, or law firm. Whoever is chosen needs to be trusted to act impartially, releasing the money at the right time to the right person.
Payment to the trusted third party can be made by personal check, wire transfer, or cashier’s check.
The earnest money will normally remain in the escrow account or securely held by the third party until closing. This allows the details of the sale to be negotiated between the buyer and the seller.
When both parties are happy, and the contingencies have been met, everything can move towards closing. At closing, the earnest money can be released back to the buyer or used to cover the down payment and closing costs.
Getting Your Deposit Back
If the deal to purchase the home falls apart, it doesn’t necessarily mean the buyer will lose their deposit. For example, if the seller decides they don’t want to sell the property anymore, the deposit will return to the buyer.
Contingencies in the purchase contract are another and more common way for buyers to get their earnest money refunded. Contingencies are clauses written into the purchase contract that gives buyers a way to back out of the deal and still keep their earnest money.
Contingencies can relate to many different aspects of the home buying process, but common contingencies include:
- The home inspection contingency. If the home inspector finds serious defects with the property, the buyer normally has 7 days to decide if they do not want to continue with their purchase.
- The financing contingency. Even if a buyer has pre-approval for the mortgage they need, things can go wrong. A buyer’s financial situation can change, leaving them unable to qualify for a large enough mortgage to buy the home. The financing contingency removes the risk if the buyer can’t find a new lender.
- The appraisal contingency. When you are using a mortgage to purchase your home, your lender will want the property to be appraised. If the home is found to be worth less than the purchase price, the lender may not provide all of the money needed. With this contingency, the buyer can back out of the deal without losing money if the home doesn’t appraise for the expected value.
- The home sale contingency. If you need to sell your current home to buy another, this contingency protects you should you not be able to find a buyer.
While these contingencies offer buyers a lot of protection to ensure they don’t lose their earnest money, they may not be a good idea in every situation. In a sellers’ market, there will be pressure to have as few contingencies as possible. When you are competing with other people to purchase the home, having fewer things in the way of getting to closing will be more attractive to the seller.
Despite the risk of losing out on a home, if you feel a contingency is important to you, including it in the purchase contract could be the best option. If you are unsure of what you should do in this situation, your real estate agent or attorney should be able to offer some valuable advice.
Why Do Buyers Lose Their Earnest Money Deposit?
When a sale falls apart, there are some situations where the earnest money will be forfeited to the seller. If the buyer decides to forgo contingencies, and then if something doesn’t work out as expected, they might lose their earnest money.
If something unexpected happens, like a big change in your life circumstances, you might want to stop the buying process. Perhaps a relationship break-up means you are unable or no longer want to buy the home. If you are lucky, the seller might allow you to get your deposit back, but they don’t have to.
The other main way to lose your deposit when buying a home is by missing contract deadlines. Home purchase contracts normally have a timeline of events that buyers need to follow. Missing these important dates, which you have agreed to, is a breach of contract. This can result in you losing your earnest money.
How Can Buyers Make Sure They Don’t Lose Their Earnest Money?
Buying a home involves a lot of money, and even though the earnest money is a fraction of this, you still need to be careful. You need to guard against fraud and the deposit being taken without rightful justification. You also need to be careful to meet your responsibilities and be certain that you want to buy the house.
Let’s look at what you can do to avoid losing your earnest money:
- Be careful when removing contingencies. While you might feel under pressure to remove most or all of your contingencies, they are your protection against losing your earnest money. If the purchase contract leaves out these protections, you are risking your deposit. Only remove contingencies if you think it is worth the risk.
- Meet the deadlines. The deadlines in the purchase contract have to be stuck to, or else you could be breaching the terms of the agreement. While it might be possible to reschedule some dates, you should do everything you can to stay on top of the requirements in the contract. Provide documents quickly when requested, and arrange the inspection within the required period.
- Put your deposit in escrow. Don’t be tempted to hand your earnest money directly to the seller, no matter how friendly the relationship seems to be. Your deposit check should only go to a trusted party, and ideally, the money should be placed in an escrow account. You should get a receipt from the law firm, title company, escrow company, or brokerage that is dealing with your deposit.
- Make sure it is in writing. Your purchase contract should state the responsibilities of the buyer and the seller, as well as important dates that need to be met. It should be clear what will cause a breach of contract and what will happen when it does. Any changes should be amended in the contract.
- Don’t overstretch your finances. When making an offer on a home, be sure that you can afford the monthly payments. Pre-approval for a mortgage will go a long way to showing you how much you can afford to offer on a home. After pre-approval, avoid any negative changes to your finances that could hurt your credit score. If you miss payments or take out a new loan, you could find you no longer qualify for the mortgage you need.
- Hire an experienced real estate agent. With a knowledgeable real estate professional on your side, there is less chance of losing your deposit. They will guide you in choosing the contingencies you need and those you can do without. They will also understand what is an acceptable earnest money deposit in the local market.
Summing Up Earnest Money
The earnest money deposit is a necessary part of making an offer on a home. It will reassure the seller, giving them the confidence to change the status of their property listing.
While paying a deposit puts this money at risk, there are ways to limit the dangers. If you have the right contingencies written into the purchase contract, you won’t have to worry about losing your earnest money should things go wrong.
You may find there is pressure to limit the contingencies you ask for, but removing them might not be in your best interests. Careful consideration and professional advice can help you decide what should be included in the purchase contract.
Above all, make sure you want to buy the home you are making an offer on. Changing your mind about purchasing the home is a good way to lose your earnest money, and there isn’t a contingency for that.
About the author: This article on “What is Earnest Money in Real Estate?” was written by Luke Skar of MadisonMortgageGuys.com. As the Social Media Strategist, his role is to provide original content for all of their social media profiles as well as generate new leads from his website.
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