One of the final steps in the home purchasing process is for each party to hand over their earnest money deposit. While most people are intimately familiar with this term, they may not be clear on what it really means.
The truth is that by not having a clear understanding of how this deposit works or why it's important, confusion is created when buyers want to make an offer on a home. According to The Real Estate Dictionary, an earnest money deposit can be defined as a sum of money given by a buyer at the time he or she executes a contract with the intent that if certain contingencies in the contract are satisfied, it will remain as part payment toward purchase price when title passes.
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This article will help you gain valuable insight into earnest money deposits so that you can get more clarity for your next purchase. Read on to learn more.
What Is An Earnest Money Deposit?
Earnest money is essentially good faith money. The amount can vary, but it's usually one to three percent of the sales price. It shows the seller that you are serious about purchasing their property, and that should help speed up negotiations or cover any problems that may arise during the inspection period.
If you back out of the contract before closing, then your earnest money could be at risk for forfeiture (you will not get it back). Simply put, earnest money is a deposit made by the real estate buyer to prove they are serious about their purchase. Some states legally require this down payment, while others encourage it but don't make it mandatory.How Does Earnest Money Work?
After accepting an offer, the seller removes their home from the market until the sale closes, which may take several weeks.
The earnest money helps assure buyers will act in good faith by serving as collateral against any financial loss if they back out without valid reasons. This also provides sellers with compensation should anything happen before closing.
Earnest money typically goes toward your down payment or closing costs (the total cost of buying the house). When making an offer on a home, you must include the deposit with your written offer.
How Much Earnest Money Should You Put Down?
The deposit you put down might determine whether or not you get the house. While the amount varies greatly from state to state, it is usually between one to three percent of the sales price but it can be higher.
There are no federal laws covering how much you have to put down as earnest money. Some states allow for 10% of the sales price, while others only allow 1%. One thing is for sure: always make sure you know what your state requires before putting down any type of deposit on a property. If there are multiple offers on one property, sellers typically prefer to work with buyers who have put down more significant deposits. This shows the seller that you are earnest about buying their house and are willing to put more money at stake than other bidders.
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Where Is The Earnest Money Held?
Your earnest money is held in a neutral escrow company account. It can be trusted under a third-party such as a legal firm, real estate broker, or title company, which means it's not given to the seller until closing.
In some cases, your real estate agent will hold the deposit until the home purchase is finalized. The real estate agent creates an escrow account to help ensure the proper distribution of funds at the end of the deal.
Once a seller accepts an offer, the buyer is required to sign a contract known as the Agreement of Purchase & Sale. This legally binding purchase agreement starts proceedings for earnest money, which enters both parties into agreed-upon terms of sale. Once it has been signed off, the buyer makes the good faith deposit into an escrow account.
What Happens If You Don't Have Earnest Money At Closing?
If you can't come up with the earnest money at the closing of the real estate transaction, the sellers may keep some or all of your initial deposit. The seller has no obligation to return the amount of earnest money that you've already given them.
Due to this risk, it's a good idea to keep your deposit in the bank until the closing of the home buying process, unless you don't mind losing it if you have a change of heart.
You can take the money out and pay for home repairs, but do so sparingly and only when you're within 24 months of closing - otherwise, you will forfeit your deposit. If a buyer does not have the earnest money at closing, they can ask for it to be carried over to the next month's payment.
This means they will not pay their monthly mortgage payment until they have made good on the missed payment. The exact terms of this option vary from lender to lender.
Is Earnest Money Refundable? The Importance Of Contingencies
In most cases, you can't get your earnest money back if you change your mind about buying the house. Your contract might allow you to withdraw from the deal, but only with a penalty provision.
You may have to pay a fee of around three percent of the purchase price, which means forfeiting all or most of your earnest money. Some contracts even require you to put down another deposit to withdraw, which means paying two deposits instead of one.
However, some contingencies can be included in the contract to protect both the home seller and the buyer. Read on to learn about the contingencies to understand how they can protect you.
Appraisal Contingency
An appraisal is a type of insurance for both buyer and seller. The lender will hire an independent third-party appraiser to determine the fair housing market value of your home, as it compares against similar properties in case you are overvalued or underpriced at sale time.
If this happens, they offer protection by allowing buyers who were given false information to get back their earnest money when buying their property.
Home Inspection Contingency
The home inspection is a big turning point for many people, and it can be the deciding factor in whether or not you want to buy that property.
When both parties put an inspection contingency into place as part of their purchase contract, there would need to be some compensation for buyers if the sellers back out at this stage.
Financing Contingency
In the event you don't get approved for a mortgage, your earnest money will be refunded. This is known as a mortgage contingency, and it is pretty common among real estate deals as not all buyers are preapproved.
Contingency For Selling An Existing Home
Some contracts also include a contingency for selling your current home. If you can't sell the house before closing on another purchase, this clause allows buyers to back out with their earnest money intact.
When To Waive A Contingency
In hot real estate markets like today’s, buyers feel pressure from their lenders and other interested parties. For instance, they may consider waiving contingencies if they know that will make them qualify for a mortgage or purchase agreement — this is generally not a good idea because those requirements are there to protect you.
How To Protect Your Earnest Money Deposit
Now that you understand what earnest money means to you as a buyer and how earnest money works, it is time to learn how to protect it. There are many ways to hold on to your funds throughout the entire transaction process, but there are a few you will want to avoid.
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Create A Written Contract
The best way to protect your earnest money is with a written contract that states the agreement between the buyer and the seller. When signing, make sure to read all the fine print thoroughly (especially first-time homebuyers — if there are no terms of sale, include them in your document).
A couple of tricky tactics include adding fine print that allows them to keep the deposit if the buyer backs out before anything is signed or requiring payment via certified funds, which will make it impossible for an earnest money refund.
Be Careful With Your Money
Do not place your earnest money directly in the hands of a real estate agent or broker. In some states, this practice is illegal. Do not give another person or entity control of your earnest money.
Homebuyers should not pay their earnest money deposit check into a trust account, escrow, or an attorney's hands. Although these are normal practices for real estate agents, they do not hold any power over the funds.
A judge cannot order them to release your earnest money either — this is why it's important to have a written contract between the two parties in order to avoid any issues in the future.
Avoid Getting Scammed
Don’t agree to pay an earnest deposit by wire transfer or personal check. Not only will you lose track of the money, but it's virtually impossible to trace and recover if your deal falls through.
Another way buyers may try to keep your earnest money is to claim the seller did not make timely payments. If this happens, make sure you have proof that everything was paid on time. It's also important to remember that sectional title units are not under the same ownership as other types of homes, so earnest money will be different for each transaction.
Earnest Money Deposit Agreement: The Final Word
People save up for years to buy houses because they are a great investment, and a place to call home. The process of buying a home is not easy, but it is definitely worth it! Typically, the more years you live in a house, the higher the value of your house will become, thanks to appreciation. It is also nice to own a home that has sentimental value or that you can create memories in.
Do not let complicated processes or terms such as earnest money deposits throw you off. Do your research, and ask your real estate agent any questions you may have. We hope that with the above information, your house buying process goes smoothly!
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