WHAT IS EARNEST MONEY AND WHY IT’S IMPORTANT
When a buyer and seller enter into a purchase agreement, the seller will take the home off the market while the transaction moves through the entire process to closing, which can take several weeks. If the deal falls through, the seller has to relist the home and start all over again, which could result in a significant financial loss. Therefore, as you near the process of making an offer on a home, your real estate agent will want to discuss your Earnest Money, a form of security deposit also known as a “good faith” payment. Earnest money shows the seller that you’re acting in good faith and committed to buying their home, and provides them with some compensation in case you back out of the deal without a valid, contractual reason.
ARE EARNEST MONEY DEPOSITS REQUIRED?
Making an earnest money deposit is not a requirement when you submit an offer on a house. However, your offer won’t likely receive serious consideration without a good faith deposit of some kind, especially in a competitive real estate market. So although it's not required, be prepared to offer earnest money if you’re serious about the home.
If you can’t afford an upfront earnest money deposit, let the real estate agent and seller know right away. If your purchase method and financing look solid, it is possible the seller will agree to move forward with the sale. If not, and you are serious about the purchase, you may be able to ask a family member or friend to assist with a gift or loan of funds for the good faith deposit. Do not, however, obtain an institutional loan or cash advance from a credit card for your deposit, as it could be detrimental to your mortgage loan approval. This payment is meant to secure the property, not put it at risk of losing it.
HOW MUCH EARNEST MONEY IS ENOUGH?
The amount of earnest money you should offer depends on the particular real estate market your desired property is in. A listing in a slow or moderate market may not need as much of a deposit as one in a hot market where there might be multiple buyers competing for the same property. Earnest money is typically around 1% to 3% of the sale price, but again, plan to pay more in a seller’s market so you do not lose the home to a stronger offer. Your real estate agent will be able to guide you on your good faith offer.
HOW DOES EARNEST MONEY WORK?
Your purchase agreement will outline how the earnest money is handled, but your deposit is typically paid to the escrow or title company, which is held until the transaction closes. You can pay via personal check, cashier’s check, money order or wired funds, depending on the terms of your contract. Once deposited, the listing will be flagged as pending, in effect removing the property from the active market. Following will be various inspections, appraisals, and any other contingencies outlined in your contract to move forward in finalizing the sale.
WHO KEEPS THE EARNEST MONEY?
Because buying a home is one of the largest purchases we may ever make, it is important to protect your investments along the way. Put everything in writing, detailing changes to the timeline and buyer/seller responsibilities. Have your agent thoroughly explain the purchase contract prior to signing it to ensure that you understand in what circumstances you would keep or forfeit the earnest money. If all goes smoothly, the deposit you paid is returned to you at closing and can be applied to your closing costs or down payment. Not all cases, however, are that smooth.
- Forfeited to the Seller If you break the terms of the purchase agreement, you will likely have to forfeit your earnest deposit to the seller. For example, the agreement typically includes a timeline of activity deadlines, such as dates for inspection completion or mortgage approval. If you miss these deadlines, there could be grounds for the seller to back out of the deal and take your earnest money with them. In addition, if you back out of the sale for any reason not listed as a contingency in the contract or decide not to buy the home because you find a better property, the seller will keep your deposit. In competitive markets, some buyers agree to non-refundable earnest money, which means the seller gets to keep the cash if the sale falls through, regardless of the reason. If you opt to use this strategy, be sure you understand the risks and don't offer money you can't afford to lose.
- Refundable to the Buyer: As a buyer, there are also a few exceptions in which you can recoup your earnest money. If the title company finds a lien against the property, you are entitled to your deposit. And, when you make an offer on a home and the seller accepts, the sale is only finalized when contingencies, or certain criteria, are met. If the seller doesn’t fulfill their side of the purchase contract (i.e., making repairs in a timely manner), it is considered a breach of contract allowing a buyer to walk away and receive a full refund of their earnest money. In addition, the purchase agreement will include contingencies that protect both the seller and buyer in certain situations, so work closely with your real estate agent to decide what contingencies you want included in the contract, understanding every scenario where you and the seller can back out and what impact that would have on your earnest money. Following are some common contingencies that enable you recollect your deposit:
- Mortgage: If you are unable to secure financing for your loan, a mortgage contingency can protect you and get your earnest money back, provided that this contingency was listed in the agreement.
- Appraisal: The appraisal contingency protects the buyer if the property is overvalued. If the fair market value of the home appraises less than the sale price, you can choose to terminate the deal and get your deposit back. Alternatively, you can use the appraisal to negotiate a new price.
- Home Inspection: When the home is professionally inspected and uncovers needed repairs, this contingency will allow you to walk away. If you still want the home, you can negotiate with the seller to have the repairs made or lower the purchase price so you can make the repairs yourself.
- Sale of Existing Home: Some contracts also include a contingency for the sale of your existing home before you can close. If you can't sell your current home within the given timeframe, this contingency lets you walk away from the deal with your earnest money.
Earnest money can be a rather unexpected expense at the beginning of the mortgage loan process, but is proven to be a valuable asset. Knowing what it is and its importance will allow you to plan ahead.
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