Earnest money is put down before closing on a house to show you’re serious about purchasing.
In today’s competitive real estate environment, you need a way to stand out. With numerous bids on the same property, sellers accept the most serious buyer.
How do you prove you’re more serious than other buyers?
Earnest money is the answer.
Understanding what earnest money is, how to use it, and how to help it make your bid stand out is important to be a successful home buyer today.
What is Earnest Money?
Earnest money is like your down payment, but you put it down in earnest’ when you bid on a home. Many also call it the good faith deposit or earnest deposit.
The money is a guarantee for the seller. When you make on offer on a home and the seller accepts it, the seller agrees to take the home off the market.
In return, you as the buyer are working on getting your loan approved, getting inspections, etc all within the written contingency timeframes that were listed in the purchase offer.
The seller takes a risk, believing that you’ll buy the home. The earnest money helps give the seller peace of mind that the buyer is working towards getting the purchase closed.
If you don’t buy the home, the seller has to start back at square one – listing and showing the home again.
This causes delays and financial difficulties for the seller.
If there’s an earnest money deposit, the seller keeps the money (unless you are within the contingency, we discuss this further down) in exchange for the hardship of relisting the home and the delays it causes.
If the transaction goes through, the closing agent applies the funds to the down payment or buyers closing costs.
How Much Earnest Money do you Need?
Typically, buyers offer 1% – 3% as an earnest money deposit.
The higher the amount you offer, the more likely it is the seller will accept your bid over others. This is especially important in today’s market. When there are multiple bids for a property, sellers look at all aspects, not just the sales price you offer.
For example, if you bid $200,000 on a home with 1% earnest money, you pledge to put down $2,000. If you back out of the contract, the seller keeps the $2,000 (if you failed to meet your obligations).
If someone else bids $200,000 with a 3% earnest money deposit, they will put down $6,000. A larger deposit of $6,000 is harder to walk away from, which makes sellers feel better about the sale going through.
Do you Always Need an Earnest Money Deposit?
An earnest money deposit isn’t a requirement. If you don’t offer one, a seller can still accept your offer. Whether or not you should make one depends on the state of the market.
If it’s a buyer’s market, there’s less competition. In other words, there are more sellers than buyers, so buyers have the pick of the litter so to speak. They don’t have to make a security deposit because sellers want their business.
In a seller’s market, however, there are more buyers than sellers. In other words, there is more competition for each home. Anything you can do to make your contract more attractive is important, including making a earnest deposit.
If you are unsure, talk with your real estate agent or mortgage loan officer.
Find out if earnest money is common in your area or if buyers aren’t offering it at this time.
You want to be competitive without giving away too much before you close on the home.
Can you get your Earnest Money Back?
As a buyer, you can get your earnest money back IF you have contingencies in your contract.
The contingencies protect you and your investment in the home. It’s a fine line you walk with sellers, though.
If you have too many contingencies, they may choose another offer, but if you don’t protect yourself, you could lose money on the deal.
Here are the most common contingencies:
- Home inspection
Viewing a home as a buyer or even with a real estate agent isn’t the same thing as having it professionally inspected. You don’t want to spend the money on an inspection until the seller accepts your bid, though.
The home inspection contingency allows you time to have the inspection completed and review it. If the inspector discovers any issues, you can either back out of the contract and keep your earnest money or ask the seller to make the repairs.
Your loan approval relies on the property’s fair market value. Lenders hire a professional appraiser to determine the property’s value. If it’s below the price you agreed to pay, you can back out of the contract if you have an appraisal contingency.
You’ll keep your good faith deposit and not be on the hook for a home that’s overvalued.
If you don’t have a pre-approval or are unsure of your ability to satisfy the conditions in a pre-approval letter, a financing contingency protects you.
If your financing falls through during the underwriting process, you can back out of the sale, with your earnest money in hand.
- Sale of current home
If your ability to buy a home is contingent upon selling your current home, you can ask for a sale of current home contingency.
This allows you to back out of the contract if you don’t sell your current home by a specific date.
It’s important to talk to your real estate agent or real estate attorney when choosing your offer. Let them guide you on the contingencies based on your current situation and what risks you can take.
In a seller’s market, you may feel pressured to skip the contingencies, but make sure you are protected in the transaction.
If you back out of the contract for any other reason, though, the seller can keep your money and relist the home. Make sure you’re 100% certain about the transaction before signing the sales contract.
Where is Earnest Money Kept?
The earnest money protects both buyers and sellers, but neither should hold onto it.
Instead, a neutral third-party, such as the escrow and/or title company should hold it in ‘escrow.’ This means no one involved in the transaction has access to the funds (this includes the seller’s or buyer’s real estate agent).
If there is a disagreement and someone breaks the contract, the title company determines who broke the contract and how to disburse the funds.
What if you Buy the House?
If you satisfy all conditions and the sale goes through to the closing, the title company releases the funds and applies them to the transaction. They decrease the funds you need to bring to the closing.
For example, if you put $3,000 down as an earnest money deposit and promised a $10,000 down payment, plus have $5,000 in closing costs, the total owed is $18,000, but since you already put $3,000 down, you only need to bring $15,000 to the closing.
Other Ways to Protect your Earnest Money
Besides the contingencies, there are a few other key ways you must protect your earnest money:
- Pay via wire transfer or certified check. Never pay cash. You need a way to track the funds and prove payment should any wrong doing occur.
- Always use a neutral third party. Don’t let the seller, his agent, or anyone else involved in the transaction hold the earnest funds. Hire an escrow company or use the title company that will close the transaction.
- Meet your deadlines. All purchase contracts have deadlines for each step, including when you need a clear to close. If you don’t have the loan commitment by the deadline, the seller could cancel the transaction and keep your deposit.
- Discuss it with your real estate agent and/or attorney. Let your agent or attorney review the sales contract before you sign it and make sure to discuss the earnest money. Make sure they feel the title company or escrow company is legitimate and that all aspects of the contract benefit you and the seller.
Is Earnest Money the Same as a Down Payment?
Earnest money and the down payment aren’t’ the same, but in the end, they come together.
The earnest money is a promise to the seller that you will buy the home to the best of your ability. The down payment is a promise to the lender that you’ll keep up with your payments and pay the loan in full.
In the end, the good faith deposit covers a portion of the down payment if the transaction closes.
The seller receives the funds either from the sale falling through or you close on the home and the seller receives the proceeds of the sale.
Should you Make an Earnest Money Deposit?
Talk to your real estate agent about the need for an earnest money deposit.
If you’re buying in a seller’s market, then you probably need a leg up on the competition.
If you’re buying in a buyer’s market, you may not need to make a good faith deposit, but you can if you need a reason to convince the seller to accept your bid.
A good faith deposit can help strengthen your offer and give the seller a reason to accept your bid over another. Know the market, the typical actions of buyers in your area, and what the seller needs/wants to accept your bid on the home.
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