What Is Earnest Money When Buying a House? Home-Purchasing Process
Once you find your dream home, you’ll enter a purchase contract that allows the seller to remove the home’s listing from the market. In that case, you’ll be introduced to the concept of earnest money, which may seem alien if you’re a first-time homeowner.
Also known as a good faith deposit, this sum of money guarantees your serious interest in purchasing the home. In simpler words, earnest money can act as a deposit for your chosen property.
If you’re interested in a new home and want to understand earnest money before investing, you’re at the right place. Keep reading to learn how it works, amounts offered, and how to protect your deposit.
How Does Earnest Money Work?
Buyers give the seller earnest money as a deposit to guarantee their good faith and strong interest in purchasing a home. With this money, the buyer can finance and conduct the title search, inspections, and property appraisal before closing the deal.
Other names for earnest money include escrow deposit, good faith money, or deposit. In most cases, the buyer must deliver the earnest money when signing the sales contract or purchase agreement for the money. Once the buyer deposits this amount, the seller typically holds this money in an escrow account before the deal is closed. Once both parties closed the deal, the earnest money applied to the buyer’s closing costs and down payments.
When the buyer agrees to purchase the property, they enter into a contract with the seller. Of course, signing this contract doesn’t leave the buyer obligated to purchase the home. In addition, since this contract is signed before the home inspection and appraisal, specific problems in the home may be revealed later that the buyer disagrees with.
This contract simply officiates the earnest money deposit (EMD) payment, which the buyer makes to ensure their offer is in good faith. In this contract, the buyer may detail the requirements and deadlines the seller must meet to complete the agreement.
The buyer is entitled to reclaim the earnest money deposit if the seller does not meet these specifications. For example, the buyer can reclaim the EMD if the inspection uncovers severe defects or the house appraisal doesn’t match the sales price.
However, the buyer must mention these contingencies in the contract to receive compensation in the case of their occurrence. The earnest money is also returned if the seller terminates the deal. Similarly, the seller receives the EMD if the buyer unreasonably cancels the deal.
Refunding Earnest Money
Earnest money cannot be refunded in every case. However, as long as the buyer acts in good faith regarding their purchase, they may be able to reclaim the earnest deposit. The refund is guaranteed if the buyer does not break contract agreements and meets decision deadlines.
There are specific conditions under which a buyer can reclaim their earnest money. For example, home inspections may uncover certain material issues within the property that weren’t mentioned earlier. In such cases, the buyer can determine who pays for the repairs or terminate the deal.
In other cases, the home appraisal may reveal the home’s value is lower than the previously agreed purchase price. The buyer can negotiate a lower price or terminate the deal. They can also refund the EMD if they can’t sell their current home as long as the contingency is mentioned in the contract.
Another contingency mentioned in the contract includes the buyer’s inability to obtain financing or loans, in which case they can retain the EMD. Of course, the conditions differ, but if the buyer decides to terminate the deal due to reasons unspecified in the contract, the seller may keep the EMD.
Example of Earnest Money
The concept of earnest money is undoubtedly complicated, so let’s present an example for a better explanation. You’ve found a home worth $100,000 that you want to purchase. Your broker will enable a $10,000 deposit to an escrow account to facilitate the home’s purchase.
You and the current owner of the home will sign an agreement or contract that states the current owner will move out of the home within 6 months. If the current owner cannot find another residence within 6 months, you may cancel the deal and reclaim your deposit.
Until moving day, the $10,000 deposit earns $500 interest from the escrow account. As long as the interest is under $600, you won’t have to consult the IRS to receive your compensation.
Earnest Money Amounts
Typically, the home’s buyer and seller are allowed to negotiate the amount of the earnest deposit. However, it commonly ranges from 1–2% of the home’s value. The current market may influence this number.
For example, hot housing markets may cause the earnest deposit amount to rise to 5% or even 10% of the home’s sale price. In most cases, the earnest money amount is only a percentage of the house’s value.
In other cases, sellers may opt for a fixed amount, like $5,000 or $10,000. The more the buyer is willing to pay in the earnest deposit, the better they can portray their serious interest in the purchase. As a result, the seller will consider the buyer’s offer more seriously.
Of course, the earnest money should be high to portray your seriousness, but buyers mustn’t let sellers coerce them into putting up an unreasonable amount. Sellers that insist buyers pay higher earnest deposits indicate an unprofessional purchase agreement.
Additionally, sellers may ask buyers to impart ongoing or periodic EMDs to guarantee their good faith throughout the home’s purchase. For example, they may request monthly earnest deposits from the buyer on a predetermined schedule over three or four months.
If the buyer does not make these deposits on time, the seller may put the house back on the market and keep certain portions of the deposit to recover certain losses.
How to Pay Earnest Money
Buyers can use personal checks, wire transfers, or certified checks to pay earnest money to an escrow account or a trust. A legal firm, title company, or real estate brokerage may possess this escrow account or trust.
The earnest deposit remains in the account or trust until the deal closes, after which it is applied to the buyer’s closing price and down payment. Of course, like any other bank account, an escrow account can also earn interest.
As a result, the longer your earnest money is held in the escrow account, the more interest you may receive if the deal falls through. However, as long as the interest amount is lower than $600, the buyer doesn’t have to consult the IRS to receive their compensation.
Otherwise, they will have to fill out the tax form W-9 from the IRS. It’s also worth noting that legal circumstances regarding earnest deposits may vary depending on the jurisdiction. For example, the EMD legislature in Washington and Minnesota are highly different.
How to Protect an Earnest Money Deposit
Protecting your earnest money deposit is crucial as sellers may try to ensure ways to keep the amount to themselves. As a prospective buyer, you can do several things to protect your earnest deposit.
First, you must ensure to mention all necessary contingencies about inspections and financing in the purchase agreement. If not, you may be able to reclaim the deposit if you cannot get proper financing or find a severe defect in the house during the inspection.
Additionally, you must ensure all contract terms are in clear writing. It’s simply not enough to discuss things with your buyer and hope for them to comply; getting every contract term in writing is crucial. This way, you can clarify all misunderstandings and set precedence for the purchase agreement’s terms.
Additionally, you must remember your right to amend the contract terms when necessary. Every iteration and amendment must be in writing and signed by each party.
Regardless of how tedious it may seem, don’t skip out on reading and understanding the contract and its terms before signing. This will also allow you to abide by the contract lawfully and make sure your seller is fair.
It’s never wise to send the deposit directly to your seller, regardless of how much you trust them. Leaving the earnest money in possession of the seller allows them to control the deposit and even refuse to release them when the time comes. As a result, it’s best to leave your deposit in a trust or escrow account to prevent being refused the funds you’re entitled to.
Finally, you must guarantee that your earnest deposit is handled lawfully and appropriately. You may transfer the funds to a reputable third party, like a legal firm, title company, escrow company, or real estate brokerage—anyone but the seller. Keeping a receipt for the funds’ placement in the escrow account is also wise.
Frequently Asked Questions (FAQs)
Who Keeps the Earnest Money if a Deal Ends?
In most situations, the buyer receives the earnest money if the deal ends. But that may change depending on how and why the deal ends. For example, buyers may reclaim the earnest deposit if a mishap occurs during the contract’s pre-determined appraisal.
That could mean the house appraisal revealed a lower value than the seller’s price. In another case, a home inspection may have revealed serious flaws within the house. However, the contract must mention these contingencies for the buyer to reclaim the payment.
If not, the seller will get to keep the earnest money. Additionally, the buyer will not get to keep their earnest deposit if they don’t purchase the house in the period mentioned in the contract.
How Can You Protect Earnest Money?
A buyer can take various preventive measures to protect their earnest deposit. That means ensuring all contingencies are mentioned in the contract, including inspections, financing, and defects in the home. This allows buyers to prevent the seller from forfeiting the deposit in case the home inspection reveals a major flaw or the buyer cannot get financing.
Additionally, the buyer must take their time to read and follow the contract and its terms. The contract may detail dates and deadlines the buyer mustn’t miss, such as for the home inspection. The buyer must complete the inspection within the deadline, or their earnest money may be forfeited.
The deposit must also be handled professionally, appropriately, and lawfully. The buyer must opt for a broker, escrow company, legal firm, or title firm to hold the funds in an escrow account instead of sending them directly to the seller.
Can You Lose Earnest Money?
Yes, there are definitely certain conditions under which you may lose your earnest deposit. For example, the purchase agreement typically details certain contingencies which specify when buyers can let the deal fall through.
That may include a failed home inspection or the buyer’s failure to sell their current home or secure financing. If the buyer decides to terminate the deal outside the previously mentioned contingencies, they may lose the deposit.
How Much Earnest Money Should I Pay?
How much earnest money you should pay depends on the current housing market and your chosen property’s condition. For example, if you opt for a hot housing market such as that of Boston and the Midwest, you’ll have to pay a larger amount to compete with other cash offers and bidding wars.
Contrastingly, you don’t need to offer too much for a fixer-upper home in a slow market. Generally, most real estate markets require an earnest deposit ranging from 1-2% of the home’s value.
If you’re a first-time homeowner, it may be hard to determine whether the seller is asking for a fair deposit amount. In that case, it’s best to consult a professional real estate agent to assess the property with the help of market-specific factors.
In the simplest terms, earnest money is the deposit you make to a seller for the house you want to buy, indicating your serious interest in the purchase. During the exchange of this deposit, the buyer and seller sign a contract detailing the conditions for the amount’s refund.
This also outlines the reasons the buyer may back out of this agreement. If the deal falls through, the buyer is returned the money, especially if the seller doesn’t meet deadlines or breaks the contract.
Knowing how earnest money works before investing in a home is crucial to ensure a seller fulfills your right as a buyer.
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