Earnest Money: What Is It And How Much Is Enough?
Kevin Graham7-minute read
February 04, 2021
If you’re ready to make an offer on a particular home and also want to show the home seller that you’re serious about your offer, there’s a way to prove your commitment. This is where earnest money comes into the picture.
We’ll look at an overview of what earnest money is, how to use it to your advantage when you buy a home and how to protect yourself once you deposit it.
What Is Earnest Money?
Earnest money is put down before closing on a house to show you’re serious about purchasing. It’s also known as a good faith deposit.
When a buyer and seller enter into a purchase agreement, the seller takes the home off the market while the transaction moves through the entire process to closing. If the deal falls through, the seller has to relist the home and start all over again, which could result in a big financial hit.
Earnest money protects the seller if the buyer backs out. It's typically around 1% – 3% of the sale price and is held in an escrow account until the deal is complete. The exact amount depends on what’s customary in your market. If all goes smoothly, the earnest money is applied to the buyer’s down payment or closing costs.
If the deal falls through due to a failed home inspection or any other contingencies listed in the contract (we’ll look at those contingencies in a bit), the buyer gets their earnest money back. The practice of depositing earnest money can decrease the likelihood of a buyer placing offers for multiple homes, then walking away after the seller takes the home off the market.
Example: Earnest Money In Practice
Tom, Mabel and Isabelle are all selling their homes. Marshall is a buyer who has looked at all three houses. He knows he wants one of them, but he can't quite decide which one he likes best. If all three sellers require earnest money deposits, there are three scenarios that can play out with Marshall's purchase.
Situation A: The Forfeited Deposit
Marshall doesn't want to decide on a single house just yet, so he makes a good faith deposit on all three houses. Tom, Mabel and Isabelle take their homes off the market and inform their other potential buyers that Marshall wants the house.
Later, Marshall decides he wants Tom's house. Mabel and Isabelle now have to put their homes back on the market and start looking for buyers all over again. Luckily, Marshall's earnest deposits are Mabel’s and Isabelle’s to keep. This offers them some compensation for the time and money they lost due to Marshall backing out of the sales.
Situation B: The Early Closing Payment
Marshall doesn't have money to spare on making deposits to all three sellers. After some consideration, he decides he likes Tom's house best and makes a single deposit. Everything goes to plan, Marshall moves in and the deposit goes toward paying off the house.
Situation C: The Failed Contingency
Marshall makes his single deposit to Tom, but when he has the home inspection done, he discovers the house is infested with cockroaches. Luckily, Marshall has a home inspection contingency in the purchase agreement, so he decides not to buy and gets his deposit back from Tom.
Why Should You Pay Earnest Money?
Earnest money isn’t always a requirement, but it could be a necessity if you’re shopping in a competitive real estate market. Sellers tend to favor these good faith deposits because they want to ensure that the sale won’t fall through. Earnest money can act as added insurance for both parties in the transaction.
Earnest money could also lower the amount you need at closing because it’s applied directly to your down payment or closing costs. Essentially, you’re just putting up some of the money earlier in the process.
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 languishing real estate listing in a slow market may not need as much earnest money as in a hot market with multiple buyers who are vying for the same property. If you plan to purchase in a neighborhood where cash offers and bidding wars are common, a higher good faith deposit is a good idea.
If you’re working with a real estate agent, they should be able to provide direction on how much earnest money you should offer. If you’re competing with others for the same property, it’s in your best interest not to undercut the earnest money deposit amount because you could lose the home to a stronger offer. If it’s a slow or moderate market, your agent can advise you if a good faith deposit in the standard range will suffice.
Is Earnest Money Refundable?
Earnest money has contingencies that protect both the seller and buyer in certain situations.
When you make an offer on a home and the seller accepts, the sale is only finalized when contingencies, or certain criteria, are met. They’re typically listed in the purchase agreement and cover the inspection, appraisal and mortgage approval, among other items.
Home Inspection Contingency
The home inspection is a common reason potential buyers back away from a deal. If your prospective home is inspected by a professional and some elements of the home come back in need of repair, a home inspection contingency can allow you to back out of the transaction. If you don’t want to back out of the deal, you could also work with the seller to have the repairs made or have them lower the price so you can do the repairs yourself.
The appraisal contingency, which protects the buyer if the property is overvalued, is equally important. The lender hires a third-party appraiser to determine the fair market value of the home and to compare it to similar properties for sale. With this contingency, if the home is appraised at less than the sale price, you can choose not to move forward with the deal and you’ll get your earnest money back. Alternatively, you can use the appraisal to negotiate a new price.
If you weren’t preapproved for a mortgage when you put your earnest money deposit down – or even if you were – and then you don’t get approved, a mortgage contingency can protect you. You have the right to walk away and get your earnest money back as long as this contingency was listed in the agreement.
Apply for mortgage approval to see your options and get a better idea of how much home you can afford.
Contingency For Selling An Existing Home
Some contracts also include a contingency for selling your existing home. If you can’t sell the home you currently own before you close on another home, this contingency lets you back out of the deal with your earnest money in hand.
When To Waive A Contingency
In hot real estate markets, some buyers feel pressure to waive contingencies; for instance, they may consider this if they’re absolutely certain they’ll qualify for a mortgage. However, it’s never a good idea to waive the appraisal or inspection contingencies. Those contingencies are there to protect you.
How to Protect Your Earnest Deposit
There are a few steps you can take to protect your earnest money:
Step 1. Use An Escrow Account
The real estate market isn’t immune to fraud. As a result, you should never give your earnest money directly to the seller or a real estate brokerage. Instead, go with a third party such as a title or escrow company, which will hold your earnest money for you.
You’ll usually pay by certified check, wire transfer or personal check. Your check should be made out to that third party, and you can keep a copy of the check and request a receipt. The funds are then held in the escrow account until closing.
Step 2. Know Your Contingencies
Contingencies protect both the seller and buyer and give both parties the means to back out of the deal. To ensure you meet your side of the contract, make sure you understand your contingencies and pay close attention to the fine print.
You should understand every scenario where you and the seller can back out and what impact that would have on your earnest money. Be sure you’re comfortable with the contingencies and are confident any actions you take won’t result in you losing your good faith deposit.
Step 3. Stay On Track With Your Responsibilities
To protect the seller, the purchase agreement will typically include a timeline for when every aspect of the process has to be met, such as the date by which you need an inspection done or when the mortgage should be approved.
If you miss those deadlines, there could be grounds for the seller to back out of the deal with your earnest money in hand. Most sellers won’t rescind the deal the minute you miss a deadline, but if you take too long, it could be a deal breaker.
Step 4. Put It All In Writing
A home is one of the largest purchases many of us will make. It's important to protect your investments along the way, which is why you should put everything in writing. This includes any changes to the timeline and buyer responsibilities. Make sure the purchase agreement lays out who gets the earnest money if the contract is canceled.
For instance, if the inspection fails and the buyer will get to keep the earnest money, state that in the contract. If the buyer has a change of heart and the seller will keep the earnest money, lay that out as well. Everything should be explained in detail in the contract.
Earnest money may seem like just another out-of-pocket cost you have to cover during the home buying process, but it's extremely important. It protects you if something is wrong with the property, protects the seller if you simply want out of the deal and proves to the seller that you’re serious about your offer.
If you’re ready to move forward with buying a home, you can get started online.
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