Everything You Need To Know About Earnest Money Deposits
When you put down an earnest money deposit, you are putting your money where your mouth is. By putting down a deposit, you are promising to follow through with your intention to buy a home. Being wise with your earnest money deposit can help you avoid pitfalls and get into the perfect house.
What is Earnest Money?
Earnest money is also known as an escrow deposit, good faith deposit or good faith money.
Earnest money is a deposit made to the seller that indicates your intention to complete the purchase of a home. Earnest payments are usually non-refundable. If the sale of the house is completed, your earnest money will go toward the purchase of the home.
Giving the seller earnest money gives you extra time to finalize your financing, complete a home inspection, and get a property appraisal before the official closing.
Earnest money is usually delivered when the sales contract or purchase agreement is signed. The real estate agent who is representing the seller will verify that the money is received in a pre-defined period of time. Up until the point of closing, all earnest money is held in an escrow account. At the closing, the earnest payment becomes part of the buyer's down payment or "cash to close."
What are Earnest Money Payments For?
Good faith money is beneficial for both sides of the home-buying process, especially in a competitive real estate market.
For the homeowner, earnest money payments provide a level of confidence that the buyer will complete the transaction and buy their home. When you are buying a home, the earnest money deposit becomes part of your closing costs and down payment.
Earnest money is usually paid for with a wire transfer, personal check, or certified check. The earnest money is held in an escrow account by a real estate brokerage, legal firm or title company until the closing.
How Much Earnest Money Do You Need?
The amount of earnest money you need varies. Earnest money deposits can be negotiated between the buyer and seller, but they are usually between 1-2% of the purchase price of the home. Some buyers prefer to go with a fixed amount rather than a percentage of the purchase price. As a general rule, the more earnest money you offer, the more seriously you will be taken as a buyer.
Several factors influence earnest money deposits, so it pays to keep an eye on the local housing market. If houses are selling quickly, the amount of earnest money you need may increase to 5% or even 10% of the selling price. If there are a lot of potential buyers for a house, a higher earnest money deposit may give you an advantage. You want your earnest money deposit to be high enough to convey your interest in the property, but not so high that losing it could hurt you financially.
Is Earnest Money Refundable?
In general, earnest money is refundable, but it depends on the specific terms of the purchase agreement and the circumstances surrounding the cancellation of the contract.
If the sale falls through due to a contingency in the contract (such as a failed inspection or appraisal), the earnest money is returned to the buyer.
However, if the buyer decides to back out of the contract after due diligence and for reasons not covered by a contingency, the seller may be entitled to keep the earnest money as compensation for the time and effort put into the transaction.
Common Mistakes Buyers Make With Earnest Money Deposits
Remember that earnest money is a good-faith promise that you will complete the transaction. It is part of your down payment and closing costs that you put down upfront to give the seller confidence that you will buy their home. There are several common mistakes people make with earnest money deposits.
You can protect your earnest money by playing it safe and being crystal clear in your contract. Include all contingencies for financing, inspections, and insurance. The clearer your contract is, the safer your earnest money is.
1. Offering Too Little Earnest Money
An earnest money deposit that is too low implies that you aren't serious about buying the house. If houses are selling like hotcakes, a low earnest money offer will be ignored. Conversely, an earnest money deposit that is too high is risky. Should the deal fall through, you may lose a large chunk of change. A good rule of thumb is to offer earnest money equal to at least 1% of the purchase price.
2. Forgetting To Add The Right Contingencies
A contingency is a clause that allows you to keep your earnest money should the deal fall through. Your contract should cover any major problems that may come up with the home inspection, title search, or home appraisal.
The common contingency is the due diligence period. This contingency gives you a set number of days to decide if you want to proceed with the purchase of the house. Should you change your mind during the due diligence period, you can walk away without losing your earnest money.
3. Not Paying Attention To Contract Deadlines
Once you have paid your earnest money, it is very important to pay attention to dates set by the seller. Many listing agents include a limited inspection period or a hard closing date in a contract. If you miss these dates, you may end up losing your earnest money deposit. Both the seller and the real estate agent want a short due diligence period, but as the buyer, you'll generally want it to be as long as possible.
4. Putting Down Earnest Money Before You're Certain
Don't risk a lot of money on foreclosed or "as is" properties. There is a lot of potential risk in buying "as is." You may end up losing your earnest money should you find a critical problem after closing. Similarly, leave those rose-colored glasses at home. Putting down earnest money before you are sure you want the home can cost you a lot of money and heartache.
Earnest Money vs Down Payment: What’s the Difference?
A down payment is a larger payment made by the buyer towards the purchase price of the property. It is typically a percentage of the purchase price, with most lenders requiring a minimum down payment of at least 3% of the purchase price. The average down payment is about 7%. The down payment is paid at closing and is not refundable. Both the downpayment and the earnest money are applied towards the cost of a home.
The main differences between an earnest money deposit and a down payment are:
- Purpose: An earnest money deposit shows that the buyer is serious about purchasing the property, while a down payment is a larger payment made towards the overall purchase price of the property.
- Amount: An earnest money deposit is typically a small percentage of the purchase price, while a down payment is a larger percentage of the purchase price.
- Refundability: An earnest money deposit may be refundable under certain circumstances, while a down payment is not refundable.
Conclusion
Putting down an earnest money deposit on a home is a big step toward homeownership, but it doesn't have to be stressful. Understanding the basics of earnest money will keep your money safe and your anxiety level low. Using the tips above, you can walk through the home buying process with confidence.