What is Earnest Money and How Can You Lose It?
What is earnest money and can you lose it? It is an old real estate term. However, it is a topic both buyers and sellers need to understand as they traverse through the home buying/selling process. Real estate purchase contracts used to be referred to as ‘earnest money’ contracts. Buyers would hand over a sum of money along with their agreement to demonstrate they were earnest in their desire to purchase a property. This is still done today.
Though always negotiable, the amount of the earnest money deposit can vary greatly depending on the area and also the current market conditions. During times when the market is ‘hot’, sellers can demand higher earnest money amounts as they could get multiple offers on their property.
An offer with more earnest money supposedly demonstrates more sincerity in interest to buy, and therefore looks like a better option. When coming up with an earnest money amount, the challenge is deciding on a dollar amount that communicates your sincerity to the sellers, but is also an amount you could live without in a worse-case scenario.
Usually if the transaction falls apart early in the process, it is not a problem and the seller will typically refund the money. Failure to reach an agreement just ties up the money and makes it unavailable to both parties. Though this may seem challenging, a seasoned real estate pro will know how to handle this type of scenario. In the end, if both parties can agree to what is fair, it is not a problem, and in some cases, splitting it could be the best option. Hopefully you now have a basic understanding of what is earnest money. Now let’s find out how it works.
How Does Earnest Money Work?
In simple words, it is a deposit made by home buyers to the home seller, which shows the buyer’s good faith in purchasing the home. With this money, buyers can also earn some extra time to get financed. They can also conduct all necessary steps to close the home deal. This includes a title search, inspections, and property appraisal. Frequently it is viewed as a deposit on a home, an escrow deposit, or good faith money.
According to the National Association of Realtors, a typical earnest money deposit can be between 1% to 2% of the home price; however, the number might vary depending on the housing market you are pursuing. In a hot real estate market, sellers might expect a higher amount since home buyers might compete for a property. If you need to learn more about how much money to offer, talk to your local real estate agents who can tell you the rates and what home sellers can expect from you.
Also, it is there to provide compensation for the home seller if the home buyer backs out from the deal without a valid reason. How the funds are handled will be specified in the purchase agreement. The sum is kept in an escrow account held by an escrow company, a seller’s real estate agency, or a real estate title company. The funds are distributed at closing and the buyer can decide to put it towards down payment or closing costs. Note that you might have to forfeit earnest money to the seller if you break the terms of the purchase agreement.
Where Does Earnest Money Fit Into the Home Transaction?
As we mentioned, earnest money is delivered when the sale agreement is signed, but it is also attached to the offer. After the funds are deposited, they are held in the escrow account until closing. Then the home buyer can decide to use it towards the closing costs of the down payment.
If a home buyer decides to purchase a home, both the buyer and seller enter into a contract. The contact does not obligate the buyer to buy the house if later reports from home inspections and appraisals may reveal problems with the home. However, when both parties enter into the contract, the seller has to take the house off the market for verifications and closing procedures. At this point, the earnest money comes into play, and the buyer makes an earnest money deposit to prove that the offer to purchase the property is made in good faith.
Afterward, the buyer can recover the earnest money if something goes wrong at some point during the process. Typically it is specified ahead of time, so the buyer knows what to expect. An instance in which the earnest money would be returned if the inspection reveals severe defects and the home doesn’t appraise at the sale price. However, contingencies must be featured on the contract for that to happen.
On the other hand, earnest money is not always refundable, and usually, it comes from home buyers breaking the contract terms. For example, if a buyer decides to go through with the property’s purchase, the seller gets to keep the earnest money. The same applies if buyers fail to meet the timeline outlined in the contract. If the home buyer has a change of heart and decides not to buy, the earnest money deposit is forfeited.
As we mentioned, the earnest money deposit is typically around 1% to 2%, but it is negotiable between the buyer and seller. Depending on the market, it might be higher or lower. For example, in a hot real estate market, the earnest money can be between 5% to 10% of the property sale price.
Earnest money is usually paid by personal check, certified check, or wire transfer into a trust or escrow account held by legal firms, real estate brokerage, or title companies. The funds are held until closing, and do not forget that escrow accounts can earn interest just like any other bank account.
Can I Get My Earnest Money Back?
First, you need to understand that earnest money is not your down payment. It can be used for that purpose at closing if everything goes well, but know that a down payment is entirely separate, and it is typically around 10-20% of the purchase price on a typical 15 or 30-year fixed-rate mortgage. If everything goes your way, the money can be folded into closing costs.
However, you need to study your contract because there are several ways you can lose your earnest money deposit. Make sure these contingencies are included in your contract so that you can get your earnest money back. With a deal that feature any of the following contingencies, you should be able to retain your deposit:
- If the home does not appraise at the offer amount – home sellers might overestimate the amount they can sell their property for, and during the appraisal process, you can find out about the actual value of the home. For example, if you make a $200,000 offer on a house that turns out to be worth only $150,000, you will not get approved on the mortgage for it, so you would have to back down. With an appraisal contingency on the contract, the earnest money deposit is refunded to you if the appraisal comes in lower than the sale price.
- You can not get financed by the lender – Lenders might disprove a on loan for multiple reasons, not just undervalued properties. Maybe during the title search, some issue arises or inconsistencies. The lender could change ownership, or there might be another hiccup in the finance process that does not allow you to get approved on a mortgage. Things happen, but if you have a mortgage contingency on your contract that addresses this issue, you can get your earnest money back.
- The property fails home inspection – It is not uncommon for properties to not pass home inspection. During this process, significant structural damages can be revealed, or the house might require a new roof. As a result, you might not agree with the seller to make the repairs; therefore, the contract that features an inspection contingency is canceled, and the earnest deposit is refunded.
To decide what contingencies to include in the contract, you need to work closely with your real estate agent. You will also need to pay attention to deadlines in the contract. If you cannot get financed before the deadline, work closely with your real estate agent to renegotiate the date. That way, you can ensure everything runs smoothly, and you can save the earnest money deposit.
It is not uncommon for buyers to agree on nonrefundable earnest money, which means that the seller gets to keep the earnest money if the sale falls through, despite the reason. It is a prevalent practice in competitive housing markets, but be aware of the consequences and understand the risks involved.
How Can I Lose My Earnest Money?
Losing earnest money is very common if you don’t understand its purpose and how it works. Therefore, make sure you do your homework and take the necessary steps to protect your earnest money. Here is what you need to do to secure the earnest deposit and make sure you don’t lose your money if the deal goes sideways.
Know Your Contingencies
We already covered a few of the main contingencies that are featured in a home transaction contract. Contingencies give both sellers and buyers a backup of the deal and protect them. To meet your side of the agreement, as a home buyer, make sure you understand the contingencies and pay attention to the fine print.
Understanding every scenario will give you a better picture of what will happen if either you or the seller backs out and what impact it is going to have on the earnest money. Be comfortable with the contingencies you made and be confident that your actions won’t result in your losing your good faith money.
Use an Escrow Account
Fraud is present in every industry, and real estate is not spared from it. That is why you need to be careful where you place the funds, as you might end up losing the deposit by misplacing it. You should know not to give the seller the earnest money directly or to a real estate brokerage. Instead, you should go with a third party, such as an escrow company.
You can choose to pay by check or wire transfer, and your check should be made out to that third party. You can keep a copy of the check and receive a receipt. The money is held in escrow until closing.
Keep Track of Your Responsibilities
Losing your earnest money can be as easy as neglecting your responsibilities as a homebuyer. Typically, home sellers are protected by the purchase agreement. It features a timeline for when every aspect of the process is met. Dates featured on the contract include inspection deadlines and when the mortgage needs to be approved.
Missing those deadlines can be an opportunity for the seller to retract from the deal and get ahold of your earnest money. Usually, sellers will not rescind the sale as soon as you miss the deadline. However, do not take too long as this could be grounds for the seller to back out of the deal. In this instance they would most likely keep the earnest money.
Write Down Everything
An excellent way to keep track of everything that is happening is to write it down. You do not want to lose your money because of organizational or absentmindedness. Protect your investment by writing down everything from changes in the timeline to home buyer responsibilities.
Make sure that the purchase agreement states clearly who gets the money if the contract is canceled. Does the buyer keep the earnest money if he has a change of heart? It’s all stated in the agreement, so lay it out and ask your real estate agent about everything. The details of the contract should be explained to you thoroughly.
Earnest Money FAQ
Here are 10 earnest money FAQ’s to get you on the right path towards homeownership.
1) Who gets the earnest money?
The buyer gets the earnest money if the deal closes as expected, the seller terminates, the home does not appraise, or they back out before the due diligence period has ended. If the buyer cancels after the due diligence period has ended the seller typically keeps the funds.
2) How do I protect my earnest money deposit?
Always put it in writing, use an escrow account to avoid fraud, know your buyer responsibilities, and understand applicable contract contingencies that could affect your deposit.
3) Can a seller keep my earnest money?
Yes, the seller can keep the buyers earnest money if the buyer cancels after the due diligence period has ended or is unable to meet contractual requirements and timelines.
4) Do you lose earnest money if the inspection fails?
Before the due diligence period ends, buyers can typically pull out of a real estate transaction without penalty (other than fees already paid for inspections/appraisals) and have their funds returned. If after the due diligence period ends, the seller usually keeps your funds depending on the contract provisions.
5) How much earnest money should you put down?
It depends on a range of factors including market conditions, price, and desirability. A good gauge is anywhere between 1% to 10% but some specialized or luxury properties may require more funds.
6) Can you negotiate earnest money?
Yes, you can attempt to negotiate the earnest money you put down on a home. However, in a seller’s market you may lose the property to another buyer if you try negotiating. The money goes toward your down payment if the home closes, so if you can afford the amount requested and really want the home, it is usually in your best interest to not negotiate this cost.
7) Why would a seller want more earnest money?
There are a variety of reasons seller’s may request more earnest money including multiple offers, no or low down payment, an extended closing date, and even lowball offers.
8) Where does earnest money go at closing?
Once received it sits in escrow with an escrow or title company or with the seller’s broker. At closing the funds are normally put toward your closing costs unless you specify differently.
9) Does earnest money get cashed?
Yes, it will be cashed and placed into an escrow account where it stays until the contract is cancelled or closed.
10) What is the due diligence period?
The time from contract agreement until a pre-determined time to allow the buyer an opportunity to have the home inspected and get an appraisal on the property. Between 10 and 20 days is typical, but norms may be lower or higher in different regions of the country.
Recap of Earnest Money Tips
Earnest money is an out-of-pocket expense during a home transaction, but it is essential for many homebuyers and sellers. It adds a layer of protection for you in case something goes wrong with the property. Moreover, it also protects sellers if you decide you want out of the deal. Finally, it proves to them that you are serious about the offer.
From the buyer’s perspective, keeping the earnest money amount as small as possible is a good idea. Though it will be credited to the buyer at closing, it essentially boils down to having more money out of pocket now rather than later. Almost always, deals proceed and the dollar amount is credited to the buyer at closing. But, in some instances, deals fall through. It is then that the issue of who gets to keep the earnest money can become problematic.
Once a contract is negotiated, the earnest money is placed in escrow with a neutral third party. At this time, the money is considered property of both the buyer and seller. If for some reason the transaction does not close, the earnest money does not automatically go to the seller. There are some cases where the money is refunded to the buyer.
For example, if during the inspection period, the buyer learns that something major is wrong with the house, they can terminate the contract and receive their earnest money back. In addition, even if the buyer is past the inspection period, but it is determined that they cannot obtain financing, their earnest money will generally be refunded if they are still within the window to obtain lender approval. These scenarios are covered in more detail later in this article. Keep reading to find out the intricacies.
However, let’s say all has gone well and the buyer backs out at the last moment. In that case, they would forfeit their earnest money. Similarly, let’s say that the seller’s job transfer changes and they no longer wish to sell their home. In that case, the earnest money would definitely be due back to the buyer. Also, in this scenario commissions would be due both agents.
This can get a bit tricky as sellers often feel they are due the money as repayment for having their house off the market to accommodate the buyer. In order to disperse the funds, the buyer and seller must come to an agreement. The third party will not release the funds without signatures of both parties. Because of this, coming up with a solution that is amenable to both parties is key.
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