Before the sale of a property can be sanctioned between a buyer and a seller, there has to be a proper negotiation. Apart from that, as a buyer, you must maintain good faith and seriousness for it to pull through. That takes us to the highlight of this guide.
If you’re ready to make an offer on a home but want to show the seller that you’re enthusiastic about it, there’s a way to do so. That’s where earnest money comes into play.
Below, we’ll look at an overview of what is earnest money? How to use it to your advantage, and the amount of money you need to proceed.
What is Earnest Money?
Earnest money, also known as good faith deposits, is the money put down to show that you’re serious about purchasing a home. It is used as a deposit on the property you want to buy in most cases. The principle behind it is that when you and a home seller sign a purchase agreement, the seller takes the home off the market while the transaction proceeds to completion.
If the deal falls through, the seller will have to relist the home and begin the process all over again, potentially resulting in a significant financial loss. If you back out as a buyer, earnest money protects the seller. A typical earnest money deposit is usually between one and three percent of the sale price, and it’s held in an escrow account until the purchase contract is finalized.
The accepted payments method you can use include wire transfer, personal check, and certified check. Your market’s regulations determine the actual amount to pay. If everything goes according to plan, your earnest money deposits will be used for your down payment or closing costs.
You get your earnest money back if the sale falls through due to a failed home inspection contingency or any other conditions stated in the contract. Therefore, putting in earnest money can reduce the probability of you making many offers and then walking away when the seller pulls the home off the market.
What Are the Benefits of Paying Earnest Money?
Having discussed what is earnest money? Let’s delve into its benefits. Earnest money isn’t always required, but it may be necessary if you’re looking for a home in a competitive market. Sellers prefer these excellent faith deposits to ensure that the sale will not fall through. Earnest money can serve as an extra layer of protection for both parties in a purchase agreement.
Since earnest money is applied immediately to your initial deposit or closing fees, it may reduce the amount you need at closing. You’re essentially putting some of the fund’s upfronts earlier in the process. That will help minimize any extra fees incurred in the home buying process.
Is Earnest Money the Same as a Down Payment?
Before we go any further, let’s clarify that your earnest money is not your down payment. Your down payment is kept separate from the rest of your finances. It’s what you pay upfront to secure your home’s financing along with a 15-year fixed-rate mortgage, and it should be ten to 20 percent of the home’s purchase price.
Consider it this way: earnest money guarantees your offer, while a down payment guarantees your financing. That means you should include your earnest money in the amount you aim to save for closing costs when calculating how much a house will cost you.
You pay earnest money when you make an offer, instead of the down payment and closing fees, which you pay when you close on the house.
How Much Earnest Money Do You Need?
You might be wondering how much earnest money you need to proceed? The amount of earnest money required is determined by the market and the property’s condition. That implies there’s no fixed amount to pay for earnest money deposits.
If you desire a particular home in an area where bidding wars and cash offers are common, you may have to make a substantial offer. However, in a slow market, a lower earnest money deposit may be appropriate for a fixer-upper.
The average good faith money deposit in hot real estate markets is between one and three percent of the property’s purchase price. For highly competitive residences with numerous potential buyers, it can be as high as ten percent. Meanwhile, some sellers prefer to set a fixed price to help weed out inexperienced bidders.
Consulting an experienced real estate agent is the best approach to deciding how much earnest money you need. They will help evaluate the property and market-specific elements before quoting a price that falls within the typical range. While it’s doubtful that you’ll lose your good faith deposit, make an offer that the seller will accept without putting your finances at risk.
What If You Can’t Afford Earnest Money?
Coming up with earnest money shouldn’t be an issue if you’re a first-time homebuyer with a sizable deposit set over for your house purchase. Approximately 60 percent of home buyers use their funds to pay for their deposits but what if you need to sell your current home to make room for a new one, and you don’t have lots of cash?
To cover the earnest deposit, you might want to use your mortgage contingency to acquire personal loans from lending services. If you do, they’ll want to view your bank account statements and look into any extensive deposits that haven’t been verified, so be honest about where your money came from.
You can also request a waiver of the earnest money requirement from your real estate agent. When the local real estate market is slow, and the seller is rushing to close a deal, this strategy is most likely to work.
What Happens to Earnest Money at Closing
The seller will most likely use your earnest money to deposit or cover closing expenses when your mortgage loan is closed.
Most buyers want to put down as much money as possible to avoid mortgage insurance, cut their monthly payments, and maybe get a better interest rate, so instructing the lender to add the earnest money to the initial deposit at closing seems logical.
Even if you don’t need the earnest money to help you make an initial deposit at closing, you may still need it to cover closing charges like property taxes and homeowners insurance. In essence, it’s a valuable asset towards the end of the closing process, but it can be an unforeseen event at the start.
Conditions for Earnest Money Refunds
You might wonder, “is my earnest money refundable?” There’s always the possibility that you’ll change your mind. In that situation, assuming everything goes according to plan, the earnest money refund is rolled into your closing costs.
Likewise, if the seller terminates the house sale for whatever reason, you’ll receive your good faith deposit back. Whatever the situation, you must be cautious and read your contract carefully because there are various ways to lose your earnest money deposit.
Make sure your real estate agent incorporates these contingencies into your contract so you can get your earnest money back if:
- The home isn’t appraised at the offer price. For instance, when you put a $150,000 offer on a house that turns out to be only worth $100,000.
- The property fails the home inspection contingency.
- You’re unable to get the required funds. That happens at times. Your lender may change hands, or you might run into another snag in the financing process.
You’ll also need to pay attention to the contract’s deadlines. Closing dates are usually set in stone, and your real estate agent can help you with that. However, if it appears that trying to secure financing may take longer than you anticipated, you can renegotiate the deadline to keep things moving along and save your earnest money deposit.
Reasons Why You Can Lose Your Earnest Money
At times, when a deal falls through, some home buyers tend to lose their earnest money. That happens due to some reasons. The following are two scenarios that could result in a nonrefundable earnest money deposit:
Allowing Your Contingencies to be Waived
If your mortgage falls through or the house is beyond repair, financing and inspection conditions protect your earnest money. However, if you end up waiving any of your financing contingency, you will lose your good faith deposit if the house doesn’t sell
Ignoring Contract Deadlines
Home purchase contracts usually include deadlines for the buyer to finish the procedure. It’s important to know that you have broken the contract if you don’t complete the transaction by the agreed deadline. If that happens, you may have to give up your good faith deposit as well.
How to Protect Earnest Money
Prospective home buyers should be aware of how their earnest money deposit is handled, as well as all of the terms and conditions that come with it. If you don’t understand something, ask questions and sign the check until you’re confident you know everything about the deposit.
Taking that into account, use the following precautions to protect your earnest money against fraud or unlawful forfeiture:
Put Everything Down on a Legal Document
Make sure your contract specifies the amount required to cancel the sale and who receives the earnest money. Include any changes to specifics such as buyer obligations and timelines.
Make Use of an Escrow Account
Never give your earnest money to the real estate broker or seller directly to avoid trust difficulties. Allow a reputable third party such as an escrow company, legal firm, title company, or a well-known real estate brokerage firm to serve as the manager. Ensure that the funds are held in an escrow account and that you have a receipt.
Familiarize Yourself With the Contingencies
Make sure the purchase contract includes provisions that safeguard your interests. Most importantly, you shouldn’t sign a property purchase agreement without the necessary protection clauses.
Always Stick to Deadlines
You must adhere to deadlines to avoid breaching the purchase contract. That way, you’re ensuring that everything goes as planned.
Buying a home is usually a significant asset to obtain, and it’s one of the most important assets you can acquire in life. While buying a house, you need to make the best offer and protect yourself in the process. During the procedure, earnest money can prove beneficial in speeding up the buying process.
Earnest money allows you to prove your seriousness and ensure the seller is committed to making the deal happen. We believe this guide has done well in providing all the basics if you’ve been asking “what is earnest money”. Thus, try as much as possible to be conversant with them to ensure your purchase agreement with a seller goes as planned.
Kris Reid is the CEO of Ardor SEO, a company that helps real estate professionals get more leads and customers to predictably grow their business.
Over the years, Kris acquired extensive knowledge of SEO and its practical applications in various industries, with the main focus on real estate.
In 2021 Ardor launched the Icons of Real Estate Podcast to share proven strategies from the top producing icon agents with the real estate community.
After obtaining the real estate license in 2022, Kris joined eXp Realty and launched Homes by Ardor, the platform that was built to be the fastest way to buy or sell a house. Homes by Ardor also provides leads for its partner companies and realtors.