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You may have heard the term earnest money thrown around in the context of real estate transactions. But what is an earnest money deposit, and why might you need one? Here, we'll review the ins and outs of earnest money so you'll understand how it works and what it's used for.
What is earnest money?
Earnest money is a sum that you, the buyer, put down to show a seller that you're serious about purchasing a specific home. It's also known as a good faith deposit.
Why is earnest money important?
Once you find a home you're interested in buying, you'll enter into a real estate contract with the seller who owns it. That home will then be taken off the market as you go through the process of having a home inspection and closing on your mortgage. After all, there's no sense in having the home stay listed if you're planning to buy it.
But how does the seller in question know you're really serious? What's to stop you from changing your mind midway through the process and backing out of your purchase contract, leaving that seller to have to start fresh and list that home all over again? The answer is your earnest money.
The purpose of earnest money is to protect a seller when a potential buyer backs out of a real estate contract. Similarly, the point of earnest money is to prevent a single buyer from entering into multiple home purchase contracts at once.
Can you get out of paying earnest money?
Earnest money is not always required in a real estate transaction. But without it, you may not find a seller who's willing to sign a contract with you. Furthermore, if you're a buyer looking for a home in a competitive market -- one with lots of interested buyers and not a lot of inventory -- then earnest money is generally a must.
Where does earnest money go?
Your earnest money check doesn't go directly into your seller's hands. Rather, it gets deposited into an escrow account until your real estate transaction is complete. If all goes well, your earnest money amount will be taken from your escrow funds and applied to your home's down payment or closing costs when you finalize your mortgage. As such, if you're serious about the home you're looking to buy, you can think of your earnest money as a means of prepaying some of the expenses you'll be liable for anyway. Your earnest money can come in the form of a personal check, but in some cases, your seller might insist on a cashier’s check.
How do you calculate your earnest money deposit?
The amount of earnest money you'll need to put down for your real estate transaction will depend on the purchase price of your home and the market you're buying in. Generally speaking, earnest money totals 1% to 5% of the cost of a home. Now, that's a pretty wide range, especially if you're looking to buy a pricier property. But that's where the local real estate market comes into play.
If you're buying in a market with limited inventory and strong buyer demand, you may need to veer toward the higher end of that range. This especially holds true in areas where bidding wars are known to spark up. On the other hand, if you're buying in an area where there's not much movement or demand, or you're buying a home that's been sitting on the market for months on end, you might easily get away with a minimal earnest money deposit -- or none at all. The real estate agent or broker you're working with can help you determine how much earnest money you ought to put down.
How do you protect your earnest money deposit?
The purpose of earnest money is to protect a seller in a real estate transaction. But what about you, the buyer? How can you be sure you'll get your earnest money check back, or have it applied to your down payment or closing costs?
The key really boils down to a solid real estate purchase contract with the right contingencies that work to protect you. These should include:
- A home that doesn't pass its inspection. If the home is found to have major structural damage and you can't come to an agreement with your seller to make repairs, you should be entitled to get your earnest money back.
- A home that doesn't appraise for its sale price. If you offer to pay a home's listed price of $300,000 but it only appraises for $250,000, you should be entitled to have your deposit returned. Incidentally, if your previous home that you're selling doesn't appraise well, it could compromise your chances of getting a mortgage, which leads to our next point...
- A mortgage that can't be obtained. If you're unable to secure financing to buy the home in question, you should be entitled to your money back. Of course, keep in mind that some buyers won't entertain an offer if you don't have a mortgage preapproval letter at the time you attempt to enter into an agreement. But unfortunately, getting preapproved only increases your chances of getting a mortgage; it doesn't guarantee it.
- A home with title search issues. If a title search on the property you're looking to buy comes back with liens or other red flags that call its ownership into question, you should be able to cancel your contract and reclaim your earnest money.
If none of these circumstances apply and you decide to back out of the deal in question, your seller will generally have the right to keep your earnest money check.
Another thing: Your home’s purchase agreement will generally contain deadlines, such as the date by which you need to have your home inspection done. Failing to adhere to the deadlines in your purchase agreement could cause your seller to back out of the deal and still be able to keep your earnest money deposit, so pay close attention to the timeframes you're bound by.
Finally, make sure your earnest money deposit is safe in the hands of an escrow company while you’re in the process of finalizing your home purchase. You don’t want to give that check directly to the seller you’re buying from; rather, it should be held by a neutral party, like an escrow agent, until you’re ready to close.
Though earnest money isn't a mandatory fee associated with buying a home, it's often a necessity. Be prepared to put down some type of good faith deposit if you're looking to purchase a home, especially if your buyer’s agent recommends it -- but before you do, do your due diligence. Read your contract thoroughly and understand the circumstances under which you will and will not get that money back. The last thing you want to do is throw your earnest money away accidentally, especially if it ends up being a substantial sum.
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