After the seller accepts your offer, you may have to make an earnest money deposit before proceeding to the next step.
Earnest money deposits are part of most real estate transactions and it pays to know as much as you can about it.
What Does Earnest Money Mean?
When the seller accepts your offer, you should get in touch with your lawyer in order to prepare the real estate purchase agreement.
Also known as the purchase and sale agreement, this contract expresses the buyer’s commitment to buy the property and it usually requires the buyer to make an earnest money deposit.
Buyers deposit the earnest money into an escrow account as a show of good faith to buy the home. Because of this, earnest money deposit is also referred to as a good faith deposit.
By signing, the seller agrees to take the home off the market for a specified period. The buyer can use this time to get financing, inspect and appraise the property prior to closing.
How Does Earnest Money Differ From Other Fees?
Aside from earnest money, you may encounter other types of deposits and fees when you buy a home. Most home buyers get confused with all the payments they have to make. Here’s a list of the most common payments and deposits you’ll make and how each of them differ from earnest money:
Due Diligence Fee
When the seller receives your offer, he or she may ask for the due diligence fee. By paying this fee, the buyer may terminate the contract for any reason within the due diligence period. Moreover, the due diligence fee is not refundable unless the seller violates the contract.
Earnest money, on the other hand, is refundable under certain circumstances. The buyer can only benefit from the due diligence fee upon closing since the seller may deduct the due diligence fee from the closing costs.
Down payment refers to the upfront payments you need to make when you purchase a property. Most lenders require a 20% down payment. Some mortgages like VA loans require zero down payment. There are also programs under FHA loans which require as little as 3.5% down payment.
Unlike earnest money where you need to deposit the funds after the seller accepts your offer, you will only need to make the down payment during closing.
Option money or the option fee refers to a small fee which is usually between $100 to $500 paid directly to the seller’s account.
An option fee allows you to terminate the contract within the option period, which is typically 10 days. During this period, you can terminate the contract for any reason. If you decide to negotiate an additional option period, you may have to pay an additional option fee.
Like the due diligence deposit, option money is non-refundable, but it is usually credited to the buyer during closing. Option fees are more common in Texas compared to other states. On the other hand, earnest money deposits are usually part of real estate transactions in all states.
When you provide an earnest money deposit, it will be held in a third party’s escrow account. A legal firm, a real estate brokerage, or a title company should maintain the escrow account. You should NEVER pay earnest money directly to the seller’s account. So when you say your earnest money is in escrow, it means that the deposit is with a third party.
This third party should follow the guidelines in the contract. Earnest money deposit should also remain in escrow until closing or until the period expires, you meet any contingency, or when the seller cancels the contract.
If the deal doesn’t fall through, you can deduct your earnest money from your down payment and closing costs.
Good to Know: While in escrow, your funds can earn interest. If the interest exceeds $5K, you have to file Form W-9 to receive this interest.
How Does Earnest Money Work?
The earnest money deposit is usually delivered with the purchase agreement or the sale contract. Sometimes, the earnest money contract is part of the offer to buy a home. The contract or agreement should how much the deposit is, the period covered and circumstances where you can get the deposit back. Buyers usually pay earnest money by wire transfer, personal check or a certified check.
If you don’t encounter any issues after signing the purchase agreement, the seller may deduct the earnest money from the down payment.
Here’s a quick illustration to give you a better idea of how it works.
For instance, you need to make a down payment of $50K and your earnest money deposit is $10K. Since you can deduct the funds in escrow from your required down payment, you only need to put down $40K ($50 K less $10K) as a down payment.
In some cases, the seller may deduct the earnest money from closing costs. Loans like Veterans Association loans, for example, require zero down payment. Since you can’t deduct, apply your earnest money for VA loans to closing costs. Take note that the seller usually pays the closing costs, so some buyers may receive a refund.
How Much Good Faith Deposit Do Sellers Require?
The seller dictates the required earnest money deposit. Most sellers require earnest money deposit between 1 to 5% of the purchase price. For a $200K home, the seller may require between $2K to $10K as earnest money.
In areas where properties sell fast, earnest money can be as high as 10% of the purchase price. For hot markets, you may lose the property to another buyer if you can’t make the required deposit. Sellers may require deposits as high as $100K in areas like the West Coast.
There are also sellers who prefer a fixed deposit which is usually between $5K to $10K.
But what if you don’t have earnest money?
Remember everything is negotiable in real estate. If you can’t afford the earnest money deposit, raise this concern during negotiation. However, sellers usually prioritize buyers who are willing to accept a high earnest money deposit.
Earnest money makes up a small fraction of the property cost. If you can’t cough up enough funds for this deposit, the seller may doubt your ability to afford the property.
If you’re the buyer, you can deposit more than the required amount in the escrow account to convince the seller how determined you are. However, don’t forget the risks! After all, you may lose your money under certain circumstances.
Is Earnest Money Required?
No, earnest money deposit is not required. Some sellers are willing to work with buyers even without this deposit. But most sellers require the deposit since it shows your intention to buy the property. After all, sellers have so much to lose when the buyer backs out.
If the seller takes the property off the market and you suddenly change your mind, the seller would be at a disadvantage.
Remember that properties sitting too long usually lose value because buyers will think there’s something wrong with it. So, most sellers shy away from buyers who are not willing to put down a deposit to make a stronger offer.
Can Buyers Get An Earnest Money Refund?
Yes, it’s possible to get the earnest money back. However, there are also cases where the seller gets to keep the deposit. Whether you get your deposit back or not depends on what happens and what the contract has to say.
There’s a higher possibility of getting your earnest money back in the following cases:
1. You completed all the necessary paperwork within the deadline specified in the contract. If you miss the date, the seller may keep the deposit.
2. The seller terminates the contract. The seller always refunds the earnest if he or she terminates the deal.
3. A reputable third party maintains the earnest money deposit. The deposit should always be in the custody of a reliable third party’s escrow account. Don’t forget to verify the existence of the account and ask for a receipt.
4. The contract you signed includes contingencies. Contingencies refer specifies scenarios that could go wrong such as inspections and financing. You can always use these contingencies to negotiate with the seller and get out of the contract without losing your earnest money.
Here’s a list of the most common contingencies:
- Appraisal contingency. If the appraised value of the property is below the offer price, you may terminate the contract without losing the earnest money deposit. Likewise, you may negotiate a lower price. The appraisal is usually done within 30 days after executing the sale agreement.
- Home inspection contingency. If the inspection report reveals that the property has serious flaws, you can walk away without losing the deposit. Inspections usually last for 10 days. The buyer may also request the seller to make the necessary repairs.
- Financing contingency. If you don’t get approved for a mortgage within the deadline, you may opt out using this contingency. This way, you’ll get your deposit back. However, you can always talk to the seller and sign a new contract to extend the deadlines.
- Title search contingency. If there are any liens on the title, this contingency will give you a way out of the contract.
- Home sale contingency. Expect sellers to make a fuss with this contingency. If they have to wait for you to sell your property before making the purchase, it could put the transaction on hold. This contingency usually allows buyers 30 to 60 days to sell the property.
How Contingencies Protect Buyers
Contingencies are highly favorable to the buyer. In fact, some sellers sweeten the pot by offering a better price if you remove contingencies.
To the buyer, contingencies are like “Get Out Free” cards and you don’t want to lose this advantage. So, before you agree to exclude any contingency, talk to your agent, your real estate attorney or both. These professionals can provide crucial insights and recommend ways to address your concerns.
If the seller is not willing to negotiate, it may be better to forgo the deal and look for another property. Signing a contract without all the necessary contingencies can make you lose your earnest money. In worst-case scenarios, you may end up making a major financial blunder.
Can You Lose Your Earnest Money?
Yes! You can say goodbye to your earnest money if you don’t have a valid reason to back out of the contract.
Canceling the contract because of first time home buyer jitters is never acceptable. If you change your mind, you’ll be donating your earnest money to the seller. So, always think things through before signing a contract.
Another way to lose your earnest money is if you miss the deadline in the contract. Take note that most contracts have a deadline of 60 to 90 months.
If your time is almost up and you’re not sure if you’ll get everything done in time, negotiate a new deadline. Sticking to the original deadline can be a huge gamble. Aside from losing the property, you can also lose your earnest money.
Pro Tip: Exercise your right to cancel the purchase the possibility of closing the deal is less than 100%.
If you back out of the contract for any reason, check what the Purchase and Sale Agreement or the contract has to say. Notify the seller of your intentions based on the requirements of the contract.
Will You Get Earnest Money Back If Your Loan Is Not Approved?
Most buyers have to get financing when they buy a new home. If you made an earnest money deposit but your loan was declined, it’s possible to get a refund.
You should also consult the Purchase and Sale agreement in this case. Most agreements include these deadlines:
- Deadline for submitting your mortgage loan application. This deadline is usually within 5 days of executing the agreement.
- Deadline for getting a loan to finance the purchase of your new home. This date is included in the loan contingency deadline and is usually within seven days from the date of settlement.
Your contract should include the deadlines above if it includes a financing contingency. If you missed the deadline, talk to the seller and explain what happened. Some sellers may agree to a full or partial earnest money refund depending on the circumstances. However, it’s always better to negotiate deadlines before they pass.
How Can You Request For The Release Of Your Good Faith Deposit?
The contract you signed should cover the process of releasing the earnest money deposit. Some contracts also include a cancellation fee if the buyer backs out.
On the other hand, if the seller changes his or her mind, you should receive an earnest money refund. Like buyers, sellers should have a valid reason for terminating the contract. If the seller backs out, you may seek damages from breach of contract. If this happens, it would be best to consult your real estate attorney.
Whatever the case may be, the company maintaining the escrow account will require written consent from both parties before releasing the funds. If there are any disagreements, the funds will continue to be in escrow until both sides come to terms or when there is a court order.
Look Out for Earnest Money Deposit Traps
Earnest money deposits provide security to both buyers and sellers. This deposit is refundable, but everything is subject to the terms and conditions specified in the Purchase and Sale Agreement.
Before signing the purchase agreement, negotiate the terms. If needed, add contingencies. While doing your own research is always ideal, don’t shoulder all the burden. Your real estate attorney and your real estate agent can help you understand what you’re signing. These professionals can also suggest contingencies that are beneficial to you.
You may care more about your hard-earned earnest money deposit than anyone else, but the right advice can help you bag an even better deal.