There are many moving parts in a real estate transaction, each of which you must fully understand for a successful home purchase. Among these is earnest money, also known as a good faith deposit, which proves your intent to fulfill the obligations of the purchase contract and complete the deal.
What is earnest money? How does it work, and who holds it? How much earnest money will you need to put up at the beginning of the sale? We’ll answer all that and more in this helpful guide by District Lending.
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Read on to answer that burning question: what is earnest money?
Short Summary
- Earnest money is a deposit to show commitment to purchase real estate, typically ranging from 1-10% of the purchase price.
- It is essential to consult with a professional and include contingencies in the sales agreement for the protection and possible refunds.
- The deposit can be applied towards a down payment or closing costs.
Essentials of Earnest Money
When securing a real estate deal, earnest money protects both buyer and seller from losses related to a failed sale. It also shows that the buyer is serious regarding the purchase contract and intends to follow through on their commitments.
This deposit is typically delivered upon signing the sales contract or purchase agreement, and its inclusion can increase the chances of the offer being accepted. In hot real estate markets, offing more good faith money can make it more likely that the seller accepts your offer instead of other buyers’ bids.
Typically, earnest money amounts to 1-3% of the purchase price and is held in an escrow account until closing.
The deposit is applied towards the down payment or closing costs at closing.
How Earnest Money Works
When the buyer and seller enter the purchase contract, the buyer will pay earnest money directly to an escrow account or trust managed by a reputable third party, such as a legal firm, real estate broker, escrow company, or title company.
The other party typically holds this money throughout the sale process, then credits it toward the down payment and closing costs or puts it toward future financing needs for the house, like the mortgage.
Determining the Right Earnest Money Amount
The earnest money you should offer can vary based on location, property condition, and competition. Generally, percentages range from 1% to 3% of the purchase price, although it can be as high as 10% in highly competitive housing markets.
Ultimately, the amount is negotiable between the buyer and seller, so assessing these factors is crucial, and determining the right amount for your situation is vital. The earnest money deposit is part of the overall deal that the buyer makes to the seller, so if you’re in a hot market and can afford it, you should consider making a significant good-faith deposit to prove that you’re serious.
How much earnest money makes a good buyer’s offer is contingent upon the particular real estate market in which the desired property is located, so it’s crucial to consult with an experienced real estate agent for guidance. In a slow market, you can offer up to 3%, but your agent can tell you what sellers are asking for now in your particular need.
Fixed Amounts and Market Conditions
Because the amount of the good faith deposit is negotiated between buyer and seller, sellers in hot markets can be more selective regarding who they enter into contract terms.
When their homes are in high demand, sellers prefer to see a much stronger commitment before they take the house off the market and enter into an agreement. In this circumstance, they may set a fixed amount that buyers must reach before they are willing to strike a deal.
Escrow Accounts and Payment Options
Regardless of the payment method, earnest money is usually held in an escrow or trust account until the transaction’s closing. Using an escrow account for earnest money safeguards against fraud and guarantees the secure storage of funds until closing.
With an escrow account, both the buyer and seller can have peace of mind knowing that the funds are protected throughout the transaction.
What Are Escrow Accounts?
Escrow accounts are good faith deposit accounts meant to hold money while fulfilling a contract; lenders also use them during a borrower’s loan to keep property taxes and mortgage insurance, which they will then pay to the correct parties.
In terms of home buying, they are relatively short-term: they are only open from the signing of the contract to the close, which is about a month and a half. Sometimes they may be held open after the home sale for particular circumstances, such as if the seller negotiated to stay in their home for a short period, but this is rare. They are managed by a third party to the sale to ensure accountability.
Because these companies are working on behalf of both the buyer and the seller, both parties will be responsible for the escrow fees associated with the account.
Escrow Account Process
If you work with a real estate brokerage firm rather than just a licensed realtor, they can handle all aspects of the transaction, including the opening and closing the earnest money deposit account. However, a real estate agent can also assist you with this.
Once the purchase contract has been finalized, the broker or realtor will send this information, along with your deposit, to an escrow company to be held throughout the title search, inspection, and mortgage finalization process. At closing time, they will release the funds to the lender, who will then apply them to the down payment and closing costs, thus closing the escrow account.
Check and Wire Transfer Options
When it comes to paying earnest money, there are several methods to choose from. Typically, earnest money is paid with a certified check, personal check, or wire transfer into a trust or escrow account.
There are three main payment methods for earnest money: personal check, certified check, and wire transfer. A personal check is a simple and convenient option, but it may take longer to clear and may not be accepted in some cases.
A certified check is guaranteed by the issuing bank, ensuring that the funds are available and providing added security. Wire transfers are electronic transfers of funds between bank accounts and are a fast and secure option for transferring earnest money.
It’s essential to consider the pros and cons of each method and choose the one that best fits your needs.
Is Earnest Money Refundable?
One of the primary concerns for buyers when dealing with earnest money is whether or not it is refundable. In certain circumstances, buyers can get back their earnest money if the seller terminates the sale without valid reason or if contract cancellation is due to outlined contingencies.
To ensure the refundability and protection of your earnest money, it’s crucial to include contingencies in the sales agreement that outline the specific conditions under which the earnest money can be returned. Some common contingencies include home inspection, financing, appraisal, and home sale contingencies.
Refund Scenarios and Contingencies
There are several scenarios in which a buyer can receive a refund of their earnest money. The first is if the seller cancels the transaction without valid justification, which almost always results in a refund. However, the four others we’ll discuss must be built into the contract terms as contingencies to receive a refund. You’ll need to talk to an experienced real estate agent or lawyer to ensure you have the contingencies to protect your assets.
Home Inspection Contingency
The home inspection contingency protects you if something drastically concerning arises during the home inspection, such as termite damage, water damage, structural issues, foundation damage, or building code violations. You can ask the seller to fix these things before the sale is complete, but if they refuse, you can ask for your earnest money back.
Financing Contingency
Usually, you will lose earnest money if you have to back out of the deal because you could not secure funds, but you can prevent this by including a financing contingency in your contract. This allows you to get your earnest money back if you can’t get a mortgage and move on to a different property.
Appraisal Contingency
This contingency refers to a significant mismatch between what the home appraises for and its sales price. If the home’s purchase price is vastly out of range with its appraisal price, you may leave the sale and get your earnest money back.
Home Sale Contingency
If you depend on the sale of your current home to be able to get this property, you can build in a contingency that allows you to get earnest money back if you are not able to sell your own home. This contingency is unpopular with sellers for obvious reasons, so you might have to negotiate hard to keep this option available.
Protecting Your Deposit
The purpose of an escrow account is to protect your earnest money deposit while the transaction continues. However, you could still lose these funds due to poor contracts or failing to fulfill your buyer responsibilities.
To safeguard your earnest money deposit, taking certain precautions is essential. First, ensure that the purchase agreement is legally binding and specifies which party will retain the earnest money in the event of contract cancellation.
Consult with a real estate agent or legal firm to ensure all applicable regulations are met, and your deposit is protected. Check that the escrow company is legitimate and legally capable of holding your money safely.
Finally, follow up with your real estate team throughout the process to ensure you follow all the stipulations outlined in the contract. Ask any questions you may have and remain responsive regarding the sale.
Potential Loss of Earnest Money
While there are scenarios in which earnest money can be refunded, you must be aware of the risks of losing your deposit. If a buyer fails to meet contract agreements or unresolved contingencies exist, earnest money deposits may be forfeited.
Failure to Meet Contract Agreements
One of the main reasons for losing earnest money is the failure to meet contract agreements. If the buyer does not adhere to the deadlines outlined in the purchase agreement or waives contingencies before the specified timeframe, they risk forfeiting their earnest deposit.
Additionally, withdrawing from the contract without a valid justification can also result in the loss of earnest money. To avoid these potential losses, it’s essential to fully understand and comply with the terms and conditions of the sales agreement.
Earnest Money vs. Down Payment
Although earnest money and down payments are both essential aspects of the home-buying process, they serve distinct purposes and should not be confused with one another. Earnest money is a deposit the buyer makes to demonstrate their commitment to purchasing the property. At the same time, the down payment is the sum of money paid by the buyer towards the property’s purchase price.
The main difference is that the earnest money deposit is intended for the seller, while the down payment is for the lender.
Application of Earnest Money
Earnest money can be applied towards the down payment or closing costs, as per the stipulations of the purchase agreement. This means the funds can help reduce the overall amount needed to complete the transaction, making it a valuable asset in home-buying.
Frequently Asked Questions
Is Earnest Money Required Everywhere?
No, it’s not a requirement everywhere, but it has become a standard element of the home purchase process throughout the United States.
Whether it’s a legal requirement depends on whether the state requires a real estate transaction to be handled by an attorney or title company. For example, in Arizona, a title company must handle real estate transactions; as such, earnest money is an essential element of the process. In other places, either a title company or an attorney can manage the sale, so a good faith deposit isn’t a legal obligation.
However, depending on the sellers’ preferences, earnest money may still be part of the buyer’s responsibilities.
How Does an Earnest Money Deposit Protect the Buyer?
The good faith deposit is an excellent idea for those selling a home: a seller takes their home off the market to enter into a contract with a buyer, so if there are problems with the contract or the buyer backs out, they will have lost out on other reasonable offers. However, it may not be entirely clear to buyers how earnest money protects them.
Do I Have To Open the Escrow Account Myself?
This depends on whether you are representing yourself during the sale or having a real estate brokerage team help you. If you are working with a real estate agency, they will manage this for you, but if you’re doing this on your own and the seller wants an earnest money deposit, you will need to get this done yourself. This is another reason why working with professionals regarding home sales is so beneficial.
Who Keeps the Money if the Deal Falls Through?
In most cases, if a deal falls through due to no fault of the seller, they will retain the earnest money as a penalty. The earnest money likely goes to them unless the seller is at fault.
The seller typically keeps the earnest money if the sale does not close due to a breach of contract on the buyer’s part. If the buyer violates the agreement, the seller may keep the earnest money as a penalty. However, the original deal’s terms ultimately determine who owns the earnest money.
Summary
In conclusion, earnest money is an essential aspect of the home-buying process, serving as a good faith deposit to demonstrate a buyer’s commitment to purchasing a property. You can make informed decisions when buying a home by understanding earnest money’s purpose, how it works, and how to determine the right amount for your situation.
District Lending is here to help through every step of the home-buying process. Get a free quote today and see how much you can save.
