What is Earnest Money?
If you've come across a home that aligns with your needs and budget, you may want to prove to the seller that you are seriously considering purchasing it. And this is where earnest money comes in.
It's the amount of money that you pay to a seller, to show them you are seriously planning to purchase that home. Some people call it a good faith deposit. So, is earnest money necessary and should you pay it?
Well, when you decide to buy a certain house, you will enter into a contract with the seller and other parties involved. However, the contract doesn't obligate you to buy that home, since the reports from the home inspection and appraisal reports, may reveal other issues with the house.
But in the meantime, the contract will require the seller to take the property off the market, awaiting the transaction to be completed - if it goes through. To prove that you are serious about buying the home, you will make an earnest money deposit.
In case the deal doesn't go through, the seller will be required to relist the house and incur other expenses. So, the earnest money deposit is designed to protect the seller, in case the buyer decides to opt out.
On average, the earnest money is approximately 1% to 3% of the property's sale price. It's usually held in an escrow account and then released either to the seller or buyer, depending on whether the transaction goes through or not.
If the deal goes through, then the earnest money deposit may be added to the buyer's down payment. In case the deal doesn't go through, the buyer may get their earnest money back due to failed home inspection or the property doesn't appraise for the listed price, among other contingencies.
However, it's also important to note that you may not always get the earnest money deposit back. For instance, if you fail to go through with the deal due to contingencies not listed in the pre-buying contract, then the seller will keep the earnest money deposit.
Earnest money is designed to cushion sellers from dishonest buyers. For example, a buyer may place offers on numerous properties, then decide to walk away from the deal after they've been delisted from the market. But when the seller has made earnest money deposits, such situations are unlikely.
Earnest Money Amount
You are not legally required to make an earnest money deposit when you are buying a home. However, it may be a requirement in certain markets, especially if the competition for available units is high.
So, how much earnest money should you pay to the seller? The amount of earnest money you will pay will depend on the real estate market competition and where the property you are interested in is located.
For instance, if the property you are eyeing is located in a competitive real estate market where several buyers are interested in buying it, then you will definitely be required to make a higher earnest money deposit.
On the other hand, if the property you want to purchase is in a slow market and the offers are few, then you will only be required to make a small earnest money deposit - or sometimes none at all.
As noted above, earnest money deposit is usually in the range of 1% to 3% of the property's purchase price. But in competitive housing markets, the deposit may go as high as 5% to 10% of the sale price.
If the seller has received multiple offers for the same property, offering a larger earnest money deposit may give you an edge over the other interested buyers. And if the deal goes through, you may negotiate a lower deposit.
The Earnest Money Contract
You will be required to deliver the earnest money deposit, once you sign the purchase or sales contract agreement. You should use a reputable third-party escrow agent to hold your earnest money deposit.
Giving the earnest money deposit to the seller directly is not recommended, regardless of any situation or circumstance. And there is a compelling reason not to do so.
If the deal fails to go through and the seller is not in a position to refund the money, you may be forced to pursue legal action - which will end up costing you even more money. To eliminate such challenges and to give you peace of mind, the earnest money deposit should be held by a third-party escrow agent.
Can You Get Earnest Money Back?
When you place an offer on a property you are interested in and the seller accepts your offer, the transaction will only be finalized once certain contingencies have been met.
Whether you will get your earnest money back or not, will depend on whether the deal goes through as well as the contingencies listed on the contract.
These contingencies are usually included in the contract, to protect the buyer and the seller in some situations. Some of the typical contingencies listed in a purchase agreement include:
- Home inspection contingency: If the property you are eyeing to purchase is inspected by a licensed professional and you discover that the property needs expensive repairs or there are some features that you don't like, then you may get your earnest money back, based on this contingency. However, you should do this within the stated timelines. If you discover something undesirable but the deadline has passed, you may not get your earnest money back if you drop out of the contract. You can also negotiate with the seller and request the repairs or necessary corrections to be made if you don't want to drop out of the contract.
- Appraisal contingency: As the name suggests, the appraisal contingency is designed to protect the buyer, in case the property they want to buy has been overvalued by a huge margin. Your lender will hire a third-party company to conduct an appraisal of the property you want to purchase. If the appraisal shows that the property is not worth the indicated sale price, you can opt-out of the deal and you will get your earnest money back, based on this contingency. But if you feel the appraisal is wrong, you can hire a second company to do it. If the second appraisal is consistent with the first one, then you can request the seller to lower the sale price. If they are not willing to do that, then you can simply cancel the contract and you will be legally entitled to get back your earnest money deposit.
- Financing contingency: Unless you are a multi-millionaire, you will have to secure a mortgage or some sort of financing whenever you are buying a home. So, what happens if you have already deposited the earnest money but you fail to secure financing? Well, the financing contingency is designed to protect you against such situations. In case you fail to secure financing for the house you want to purchase, you can walk out of the purchase agreement and request back your earnest money, based on this contingency. Make sure you read and understand all the details included in the financial contingency before signing it. You can also request your mortgage lender or real estate agent to explain anything that doesn't seem clear.
- Selling an existing home contingency: In this contingency, the transaction will only proceed if you manage to sell your existing home. So, if you manage to sell your current home within a certain date, then the contract will proceed. But in case you fail to sell your current home within the stipulated deadline, you can cancel the contract and request for your earnest money deposit. A home contingency is put in place to give the buyer ample time to sell their current home. Also, it helps to prevent the issue of the buyer holding two mortgages concurrently. A home sale contingency can also help you to gather the money that you need to make the transition into the new home.
It's highly advisable to use a professional real estate agent when buying a house. Your agent will evaluate the property's value and the level of competition and then recommend a fair earnest money deposit. Also, a professional real estate agent will help you to go through the contingencies and point out all the potential red flags.
Protecting Your Earnest Money
Earnest money deposit is not pocket change. It can run into thousands of dollars, depending on the value of the property you are eyeing as well as the current market prices. So, you need to put in place some measures to protect your earnest money. Here are some tips that you can implement to protect your earnest deposit.
- Use a third-party escrow service: As you may expect, the real estate industry is full of scammers and fraudsters. And some may entice you with insane deals and start pressuring you to pay earnest money deposit, to book the property. Regardless of how great the offer is, you shouldn't give money directly to any seller or any real estate company. Instead, you should only deposit the earnest money to a third-party escrow service. Your funds will then be safely held by the escrow company until closing.
- Read and understand your contingencies: Contingencies are usually put in place to protect both the buyer and the seller and cushion them against loss in case they want to back out of the deal. If you are the buyer, make sure you read and understand your contingencies before you sign the purchase agreement. Ensure there are no loopholes that the seller can exploit to refuse to refund your earnest money deposit.
- Adhere to your responsibilities and closing deadlines: Purchase agreement usually comes with various timelines, where the buyer is supposed to finalize various aspects of the closing. So, if you miss those timelines, the seller may be legally entitled to abandon the deal and walk away with the earnest money deposit.
- Have a written and signed contract: It doesn't matter whether you are dealing with the most trustworthy seller on the planet, everything should be put in writing and signed by both parties. So, ensure the purchase agreement, the earnest money to be paid, the responsibilities of both parties and the timelines are clearly communicated and put down in writing. The contract should also indicate who walks away with the earnest money if the deal falls through, based on the included contingencies.
What is a Down Payment?
A down payment is a cash payment that you make upfront, as part of the property's purchase price. It's paid directly to the seller, and it doesn't come from the lender or mortgage financier. For instance, if you are buying property worth $100,000 and you pay $20,000 to the seller, your lender will pay the remaining balance of $80,000.
The minimum down payment for a home purchase will depend on the lender, the value of the property you intend to buy as well as the type of mortgage that you've applied for. But for most of the conventional loans and mortgages, you will be required to make a 20% down payment.
If you can afford it, then it's highly advisable to make a larger down payment. It will lead to a lower interest rate, lower upfront costs and ongoing fees, a lower monthly mortgage payment as well as more equity for your home. Also, a higher down payment increases your chances of securing a mortgage.
Earnest Money Deposit vs. Down Payment
In a nutshell, earnest money deposits the money that a buyer offers to a property seller, to show their commitment and seriousness. On the other hand, down payment is the money a buyer must pay in cash to a seller, for the lender to approve their mortgage. As much as both payments are made upfront and they are part of the home buying process, they are not the same. Knowing their differences and where they are applied will help potential home buyers to avoid common mistakes.