When purchasing a new home, there are many ways to gain a competitive edge over other potential buyers. One of these ways is by using the idea of earnest money. Earnest money can show a potential seller that you are more serious than other bidders and help them move forward with you with more confidence that the sale will be completed.
What is Earnest Money?
Earnest money, sometimes known as a good faith deposit, is a sum of money you put down as somewhat of a downpayment on a home to show a seller you are serious about buying.
Without earnest money, after entering into an agreement for the home, the seller will typically take the house off the market. If the buyer then backs out, the seller has now wasted time and money dealing with the buyer that backed out. Because of the non-refundable nature of earnest money, by putting down the good faith deposit, the seller can move forward with more confidence.
How Does Earnest Money Work?
In most cases, earnest money acts as a deposit on the property you’re looking to buy. You provide the money when signing the purchase agreement or the sales contract. Sometimes, you can include it as part of the offer. By nature, earnest money is non-refundable if the buyer backs out. However, both the buyer and seller can sign a contract that defines any terms and conditions that need to be met for the earnest money to be refundable.
Earnest money is most used during a seller’s market or whenever buying a property in high demand. Many potential buyers means several might be using earnest money to sway the odds in their favor, so a larger deposit may be needed to convince the seller to select your offer over others. With the use of earnest money, you may also get more favorable contract terms.
In many cases, the earnest money of the accepted offer is applied toward the down payment or closing costs paid by the buyer. This means the earnest money is not an additional cost to the buyer. Instead, it’s more of an upfront payment on either cost they would need to pay anyway.
How Much Earnest Money?
The amount of earnest money on any offer can vary, but it is primarily up to the buyer to determine how much to offer. Typically, earnest money is roughly 1% – 3% of the purchase price but can go as high as 10%. Earnest money amounts tend to be higher when the real estate market favors sellers and\or the property is in high demand. Conversely, earnest money offered can be lower when the real estate market favors the buyers, or the house is more of a fixer-upper property. Real Estate agents familiar with the market and area will best help guide you when determining how much, if any, earnest money you should be offering.
Why Pay Earnest Money?
Simply put, earnest money is not a requirement but could be the difference-maker in getting the home you want. Again, it’s not an additional payment as it can be applied to closing costs or the down payment on a home.
How Earnest Money Is Paid
Paying earnest money is a relatively simple process. Buyers can pay by using a personal check, certified check, or by wiring the money. The money is typically held in an escrow account, which is an account that a neutral third party holds. The money is then held in the escrow account until the closing of the property or if the money needs to be refunded to the buyer.
Reasons You Can Lose Earnest Money
Part of the risk with earnest money is that the buyer can lose it if the deal falls through. Two scenarios that may lead to the forfeiture of your good faith deposit are:
Waiving your contingencie\Failure To Have Contingency
There are several contingencies (next section) that will allow the buyer to redeem their earnest money in specific scenarios. However, suppose those contingencies were waived for any reason or were never agreed upon in the first place, and the deal falls through. In that case, the buyer will not be able to get their earnest money back.
Not Meeting Contract Timelines
Most home sale contracts will have a closing date in them. If the buyer fails to secure funds and doesn’t close on the deal before the agreed-upon date, they can be seen in breach of the contract. If a new date cannot be agreed upon and the deal is broken, the buyer will likely not get their earnest money back.
How You Can Get Earnest Money Back
Most of the time, if a deal falls through, the earnest money is non-refundable. However, the buyer and seller can agree to contingencies in which if the deal fails to complete; the buyer will get their money back. Here are a few common examples of those conditions.
Home Inspection Contingency
A common earnest money contingency is the home inspection. Before any home sale, a home inspection is typically done to find anything that needs repair or might need to be brought up to code. If anything is found that would require significant repairs, a buyer could recoup their earnest money. As always, there is always the possibility to negotiate terms on who will cover the costs on any possible repairs to keep the deal moving and earnest money still in play.
Another common contingency is the appraisal contingency, which protects the buyer if the property is overvalued. The lender will hire a third-party appraiser to determine the fair market value of the home. The appraiser will typically compare the home to similar properties for sale in the neighborhood. If the home is appraised at less than the sale price, a buyer can choose not to move forward with the deal and get the earnest money back. A new price can also be negotiated if both parties agree.
The financing contingency will come into play if the buyer cannot secure a loan for the purchase of the home. This may be because the buyer was not pre-approved for a mortgage or was approved for one far less than the sale price, and the bank won’t approve the higher loan. No matter the reason, if the buyer can’t securing financing and this contingency is in place, they can get their earnest money back.
Selling An Existing Home Contingency
Often, the purchase of a new home relies on the ability of the buyer to sell their current home. A contingency can be agreed on that if the buyer can’t close on their existing home before the closing date on the new home, they can back out of the deal while getting their earnest money back.
When To Waive A Contingency
It is never a good idea to waive any contingencies as they are there to protect the buyer. There is often fierce competition in real estate markets. Buyers will do whatever it takes to get a home, even if that means waiving these protections. Then when the unexpected happens, and they can’t close the deal, they are out a lot of money. Always keep the contingencies in place and make sure both you and your real estate agent understand them.
Protecting Earnest Money
Earnest money is a tool you can use to gain an edge over others in the real estate market, but you should also protect yourself as not to lose this money:
- Put everything in writing: Verbal agreements are great but can leave room for misinterpretation. Put everything about the earnest money into writing in unambiguous and concise wording. Your contract should define who will get the funds under all conditions. Any changes made to a contract should be put in writing as well.
- Use an escrow account: Never give earnest money to any but a third party. Many companies are strictly in business to provide escrow accounts. Legal firms and title companies can be used too. Giving money to anyone involved in the sale can only lead to trouble. Always confirm that the funds are in the account as well.
- Understand the contingencies. As mentioned earlier, the contingencies are there to protect the buyer and should never be waived. Make sure the exact conditions of all contingencies needed to lose or refund earnest money are understood by all parties involved.
- Meet your duties as a buyer: If you don’t want to lose your earnest money, then you’ll need to do what is expected of you as the buyer. Meeting specific timelines to obtain funding, closing on the home, and other critical points along the way should all be fulfilled.
What If You Can’t Afford Earnest Money?
When purchasing a home, most first-time homebuyers have money put aside to reach the 20% downpayment to buy their first home. So putting down the initial 1% – 3% earnest money shouldn’t be a problem in this case.
However, sometimes to buy a new home, buyers need to sell their current home first and don’t have the cash available to put down for earnest money, what then? If required, lenders will allow for a friend or family member to provide the earnest money. It will need to be documented, as lenders typically look at buyers’ bank accounts before approving any loans. Any large deposits that are unverified could be a red flag, so it’s best to let them know where the money came from.
Earnest money can give buyers an advantage over other buyers in a hot real estate market. Putting 1% – 3% of the purchase price into an escrow account can give a seller a bit of extra confidence that they’ll be able to complete the deal promptly. Of course, there are always things that can go wrong on either side, so it’s best to protect yourself with contingencies when using earnest money. Otherwise, you risk losing your money and walking away with nothing. As with any home purchase, always have your real estate agent and lawyer look over any paperwork before signing.
Jeff is a fan of all things finance. When he’s not out there changing the world with his blog, you can find him on a run, a Mets game, playing video games, or just playing around with his kids.