What is Earnest Money?
Every real estate seller is mostly looking for serious buyers and not window shoppers. And there are various ways they ensure this. One major way is through earnest money.
In real estate financing, earnest money is a deposit or payment given by an interested buyer to the seller of a home offer, to show commitment to the purchase.
This deposit makes clear the buyer’s seriousness about purchasing the home. It also confirms to the seller that the buyer will be true to their own end of the purchase deal.
Take for example a survey carried out by the Atlanta Real Estate Group which showed that 78% of homes on the market had multiple-multiple offers.
In such situations, the seller would require a buyer to show deep commitment.
The seller of the home will make clear the terms and amount of the earnest money deposit. However, the earnest money after a particular period of time could become non-refundable.
This period is known as the option period. Nevertheless, some agreements might state that under certain conditions the deposit can be refunded to the buyer.
Most times earnest money is held in a trust account or escrow until the deal is closed and the funds are utilized as part of the homes purchase price.
Keep in mind it is not to be mistaken for closing costs or down payments and we will get to that later.
Earnest money will make your offer to purchase a home, stand out from the ones from other applicants.
WHAT IS THE PURPOSE OF EARNEST MONEY?
A recent survey showed that interest in purchasing homes is on the increase in the United States, which proves an increase in the amount of buyers purchasing properties.
But how do you know who is a serious buyer among those simply interested?
Let’s answer that like this; when you walk into a restaurant and ask to join as a cook, they likely will ask you what sort of meals you can make, just to ensure that you are worth their time and will not end up wasting it.
When selling properties, people would hate to have their time taken by an unserious buyer with a mirage interest that will properly take their eyes of real buyers.
This is why the earnest money deposit is essential.
Also, known as good faith payment, it showcases the genuine interest of the buyer to the offer.
HOW MUCH IS NEEDED FOR EARNEST MONEY
How much you need for your earnest money deposit will differ based on the market.
There is no definite amount or figure, but most times it is equivalent to 1% to 3% of the buying price of the home offer.
Nevertheless, there are certain situations, when an escrow payment of $1000 is good enough, it basically dependent on the home seller.
If you’re a buyer, it’s quite wise to try to get away with the smallest deposit amount possible. This is because there may be cases where you’d need to back out of the agreement.
However, keep in mind that sellers will be targeting to get a large earnest payment because they need to be certain of the seller’s commitment.
In a buyers market with poor home offer sales, as a buyer, you would be able to deposit a much smaller amount on the property due to you being the only offer.
If you decide to purchase a home from a buyer’s market, where numerous bids are commonplace, the seller most likely will require a bigger deposit.
You need to work with an experienced and qualified real estate agent who will help you guide you through the entire buying process, including the appropriate amount of earnest money.
What is the Difference between Earnest Money Deposit and a Down Payment?
Down payments and Earnest money are both major aspects of the home buying procedure, but they certainly are not the same thing.
However, in both scenarios, the more cash you offer, the higher your chances of securing the home of your choice.
SO WHAT’S THE DIFFERENCE?
As we’ve seen already a strong good faith or earnest money deposit basically acts as a surety and compels the seller of the home to accept the buyers offer.
This acceptance makes him take the house off the market instead of waiting for offers from other prospective buyers.
In situations where the seller has numerous offers, a high earnest money deposit would certainly set you aside from the competition of additional buyers.
For very expensive homes, your real estate agent may be able to get a lower deposit amount.
As a rule of thumb, earnest money is as low as the seller is willing to take and as much as the buyer is capable of offering.
If you plan to make an earnest money deposit, always ensure the money in your bank account can cover the deposit amount before you give the seller the check.
The EMD is generally transferred to the title company once the contract is totally ratified and it will be cashed shortly after that.
The card is kept in an escrow account till the deal is closed. If however, the agreement goes as planned; the earnest money is most times applied to your down payment.
In the scenario you negate the deal due to contingencies stated in your offer, such as the outcome of the home inspection, you most likely will get your earnest money deposit refunded.
Ensure that the refund agreements are studied carefully before making deposits.
WHAT IS DOWN PAYMENT?
The down payment, on the other hand, is the number of funds the lender requires you to place down with regards to the purchase of the home.
Generally, it is based on a certain percentage of the sales price.
This amount is most times established quite early in the loan application procedure with your lender.
Down payment amounts can differ from 3.5% for FHA loans to 20% for particular conventional loans. The source of the money usually has to be checked and certified by the lender.
With high down payments, you’ll get very high chances of getting approved for a mortgage. Also, you’ll get reduced monthly mortgage payment and greater equity in your new property.
Now we know down payments and earnest money deposits are very different things let’s see what the various contingencies a buyer would need to ensure are included before making his/her deposit to a seller.
Before that though, we need to know what exactly a contingency is.
WHAT ARE CONTINGENCIES?
Most contracts, whether related to property or not, possess various provisions which outline the conditions under which the deal or contract could be canceled.
These provisions are termed as “contingencies”. Simply put, the home offer is contingent on some particular listed things.
These contingencies are legal loopholes that permit you to back out of your contract, should any of them happen to occur. Basically, you can have contingencies for anything that can cross your mind.
Yes, that means you can whip up a contingency which states that “This offer is contingent on the walls colored blue” or ” This contract is contingent on grass being on the lawn”.
If you were to add those and the lawn had no grass or the wall was colored white, you would back out of the deal and cancel it without any repercussions.
Now, these are just examples with the intention to illustrate how a contingency works. So what type of contingencies would you actually put in a home offer?
First, you must understand that the more contingencies a buyer puts in an offer the less likely a seller will be to accept it.
If for instance, someone offered to purchase your house but only if 70 minor contingencies occurred, would you feel ok with it? Certainly not!
However, keep in mind that contingencies are most times necessary to prevent yourself from getting into things you didn’t expect.
How to know which exact contingencies to add to a deal depends totally on the nature of the contract itself and who you are giving the offer too.
If you are competing with so many people for a particular piece of real estate, you would have to include very few contingencies than you would if you were submitting an offer for a contract with no competition
Now let’s have a look at the various contingencies you’d likely have to include in your home offer:
Financing contingents are extremely important. A financing contingent declares that the agreement or deal is contingent based on mortgage approval.
For instance, if as a buyer your loan is denied for reasons beyond your control, then you will be able to get back your earnest money deposit.
Just imagine what would happen if you wanted to purchase a home but when the deal is about to close, you suddenly found out your financing didn’t work out as planned?
As disappointing as that could be, you’d end up losing your earnest money deposit if you do not have financing contingency to cover you.
The financing contingency will permit you to back out of the deal and keep your earnest money should you be incapable of securing a loan.
If you are paying in cash for the property, you obviously won’t have any need for the financing contingency, and your offer will certainly look a lot stronger to the seller.
Some buyers choose not to add a financing contingency, even when using a loan.
This is because it can set their home offer apart, since the seller is aware that they’ll either get the earnest money deposit or the deal will close, regardless of what happens.
Keep in mind though that if you opt for waiving the financing contingency but have to pay with a loan, this would increase the risk of parting with your earnest money deposit if something goes wrong with your financing.
As a matter of fact, research has shown that middle-class Americans find it extremely difficult to secure financing, so having a deal without this contingent might be very risky if you fit into that class.
2. Sell Present Home First
If you reside in a home presently that you have to sell first before being able to get approved for a new mortgage, this contingency will shield you.
Hence, if you aren’t able to sell off your home and therefore are unable to complete the sale, you’d be able to back out of the agreement.
Keep in mind that this type of contingency is not easily accepted by sellers nor are they thrilled to see it, so this could reduce the chances of your home offer being accepted.
3. Home Appraisal Results
This contingency is based on the results of a home appraisal. Lenders use the home appraisal to grade the market value of the property.
If for example, the appraisal returns lower than the previously agreed buying price, you can either ask for the price to reduced or get out of the deal altogether.
4. Visible Title
The property deed or home title is a document which reveals the legal owner of the property.
A title firm will run a thorough title check to make sure the seller of the home has the legal right to put the property on the market. It will also check that there is wrong information on the title.
5. Home Inspection
Home inspections are set up and paid for by buyers. Even though it isn’t necessary, it is greatly recommended. If your contingency as a buyer covers the inspection of the property.
You can make the seller pay for all repairs that are required to be finished before the deal is closed.
It’s only possible to find out all there is to about the property when you go through it for a quick tour. Furthermore, you can go with a professional inspector to look out for any imperfection they can see about the property.
An inspection contingency, therefore, offers you with the ability to check out everything about the home within a particular timeframe and pull out of the deal if you discover something you did not expect.
With regards to residential homes, a 10-day home inspection contingency is typically accepted. What this means is after 10 days, you can no longer refer to the contingency nor is it applicable.
These types of contingencies are quite common in most real estate contracts.
However, some experienced buyers do choose to overlook this contingency, choosing to rather take the risk in believing that nothing unexpected will be found out during the inspection.
If the unexpected does happen and such buyers have to back out, they’ll most probably lose their earnest money deposit.
Regardless though of the 10 days inspection norm, some investors or buyers choose shorter inspection periods like 3 days.
Keep in mind though, that you must be able to get enough details of the house within the time frame you choose.
WHO KEEPS THE EARNEST MONEY DEPOSIT?
The earnest money deposit shouldn’t be handed over to the seller directly, except in cases where it’s something negligible like a dollar.
Rather, the deposit is typically kept by a third-party, most likely the attorney handling the deal or the title company.
This makes sure that the rules that govern what occurs to the earnest moment deposit are obeyed.
This usually happens when the deal has been signed and accepted by both parties and not before that.
If you are going through a real estate agent, he/she would most likely direct you were around when to drop off the check for the earnest money deposit.
WHAT HAPPENS TO THE DEPOSIT?
I’m sure you have been thinking, what exactly is the earnest money deposit used for? What ends up happening to it?
Well, there are 3 possible scenarios which could play out, depending on how the deal goes.
1. If the contract works out, the earnest money deposit becomes part of the cash you would be required to bring to closing as a buyer.
For instance, if your down payment and closing costs added up to $40,000 but your earnest money deposit was $2000, you would be required to bring only $38,000 to the closing meeting.
This is as directed by the attorney responsible for closing the deal or the title company.
2. If the contract doesn’t work out and the buyer is void of a legal reason to cancel, then the earnest money deposit is given to the seller, and the seller collects the earnest money.
3. If the offer does not work out and the buyer has full legal rights to cancel, the earnest money deposit is refunded back.
Keep in mind that these legal reasons mentioned are the contingencies we previously looked at.
IN WHAT SITUATIONS CAN THE EARNEST MONEY BE FORFEITED?
1. When you waive your Contingencies
In extremely competitive markets, it’s quite the typical thing to see buyers who waive contract contingents relating to inspection or financing. It might look very tempting to do the same if you are chasing after a specific property you really want.
It will make you appear as a very attractive buyer to the seller. However, it comes with massive risks. And you guessed it right; you might end up losing your earnest money deposit to the seller.
For instance, the financing contingency assures you that you will get your earnest money deposit back if financing isn’t approved.
Also, with the inspection contingency, you can cancel the contract and get your earnest money deposit refunded if there are certain issues discovered during the home inspection that made you rethink the offer and decide not to purchase it again.
If as a buyer you waive all contingencies and you face home defect or financing issues, you won’t be able to have your deposit refunded if you back out of the deal.
However, in the case of inspection contingencies, if you really want the property and it’s a competitive one you may ask for an inspection of the home before proceeding to submit the offer.
That way you’d be able to tell ahead of time if there are major issues with the property that would end up making you not to purchase it. Then you can submit your offer without the home inspection contingency.
With regards to the financing contingency, you may have to waive it to compete with buyers coming with cash? However, you need to be totally sure that the bank will give you the needed approval,
2. Ignoring the Contract Timeline
Your contract with any seller most times sets particular time frames that you need to follow to do inspections and secure financing.
If you try to back out of the contract once any of the deadlines are crossed, you would forfeit your earnest money deposit.
Generally speaking, so far as you’ve made all possible effort to stick to the contract timeline, most sellers will give you an extension if the bank or lender requires some more time or other uncontrollable circumstances affect things.
All extensions have to be written and signed by both the buyer and seller.
3. You Change Your Mind
If you suddenly get a change of mind about the property you intend to purchase, but there isn’t anything wrong with the home or the financing, you’d most likely lose your earnest money deposit.
The earnest money deposit acts as a shield for sellers when they decide to take off their property from the market.
If as the deal is about to close you suddenly decide you do not want to buy the home, the seller will get to have the earnest money deposit as compensation.
This is for the money and time they must spend on putting their home on the market again and finding another buyer.
Keep in mind that if you change your mind with no reason, you may not just lose the earnest money deposit alone. The seller could file a suit against you for specific performance as well as the tertiary cost inclusive.
For example, say the seller’s packed out of the home and the home is staged by introducing new furniture.
When the property goes under contract, the seller takes out the furniture in order not to incur more staging costs.
If the buyer suddenly decides not to buy any more with no specific reason, the cost which the seller bears would now be quite high, and it may be greater than the earnest deposit, so he/she sues.
The earnest money deposit is a way to show commitment to your interest to purchase a property as well as a shield to sellers of properties.
It ensures that both parties get what they want and are able to comfortably close deals without questioning the commitment of one another.