Earnest Money: Everything You Need To Know
Earnest money is a term used widely in the real estate industry. If you’re looking to buy a house or have sold a property in the past, you may be familiar with earnest money, but it may be a new concept for you if you’re buying or selling your first home. So what is earnest money? Read on to find out.
What Is Earnest Money in Real Estate?
Earnest money is a form of deposit, which some buyers will pay to show that they are genuinely interested in buying and serious about their purchase. In most cases, it is money paid into an escrow account after the seller has agreed to accept the buyer’s offer.
An earnest money deposit is not essential, and not every sale will require the buyer to make an earnest money offer. It is common for buyers to offer to pay earnest money in scenarios where there are several interested parties, the market is moving fast, and houses are in high demand. If you are competing against other buyers, an earnest deposit could help you gain an advantage.
Investopedia gives us the following earnest money definition:
"Earnest money is a deposit made to a seller that represents a buyer’s good faith to buy a home.”
What is a Reasonable Offer?
There is no universal answer to this question, as every buyer may find themselves in a different situation. According to the National Association of Realtors, the average earnest money deposit is between 1% and 2% of the total home value. The amount you pay varies greatly depending on the value of the property and the market conditions. If houses are selling rapidly and there is fierce competition among buyers, interested parties may be willing to pay more than that.
If you view a property and want to make an offer and move the deal forward, it’s always beneficial to talk to your real estate agent and get an idea of how many buyers are interested and what that means for you.
If there are more buyers than there are homes on the market and demand is growing, you may need to pay more to make your intentions clear and gain an advantage over other buyers. Your real estate agent and the agent representing the vendor will be able to give you an idea of how much earnest money to offer.
Tread carefully when competing against other buyers for the same property. If you try to undercut another party’s deposit and lose out to another buyer who puts a better offer forward, you could lose money.
What Happens When You Pay Earnest Money?
1. Paying your earnest money deposit
When a buyer finds a home they love and makes an offer, the seller may agree to accept the offer and take it off the market. The buyer agrees to pay earnest money to give the seller confidence while the required documentation is processed and the sale goes through. In most cases, the earnest money deposit is kept in an escrow account.
2. Your deposit is stored safely
The purchase agreement signed by both parties will outline how earnest money funds are stored. Usually, the funds are kept in an escrow account until the deal is complete. The account is handled by an escrow or title company. It is not wise to pay the seller directly, as this makes it more difficult to get the funds back if the sale falls through. The purchase agreement you make with the seller, and a third party should protect your earnest money.
3. Your money is released at closing
Your earnest money deposit will be released when you close the deal on your home and become a homeowner. In most cases, the funds will be added to your downpayment or used to cover the closing costs.
Is Earnest Money Refundable?
The purchase agreement details contingencies and exceptions, which affect both the buyer and the seller. In some instances, buyers can walk away from the property without forfeiting earnest money, and there are also circumstances where sellers may keep the earnest money. It’s crucial to be fully aware of the agreement's details to make sure that you understand what will happen if things don’t go to plan.
Contingencies That Enable Buyers To Keep Earnest Money
The terms of purchase agreements may vary, but here are some common contingencies that may enable buyers to keep their earnest money:
- Mortgage contingency: if you are unable to get the mortgage you need to buy the house, and you have a mortgage contingency in your agreement, you shouldn’t have to forfeit the earnest money deposit. The mortgage contingency may also be referred to as the financing contingency.
- Inspection contingency: if your home inspection flags issues that cause concern, you have the right to withdraw and keep your earnest money if this scenario is included in your purchase agreement. A bad report is one of the most common reasons buyers pull out of a purchase agreement. If your inspection reveals problems that need urgent attention or repairs that will be costly, for example, you may think twice about proceeding.
- Appraisal contingency: this contingency is designed to prevent the buyer from overpaying. If the property is overvalued and the offer price significantly exceeds the market value, the buyer has the right to renegotiate with the seller or step away.
- Selling your current home: some buyers include a contingency, which allows them to keep their earnest money if they are unable to sell their existing home and proceed with the purchase.
Scenarios That Enable Sellers To Keep the Earnest Money
Earnest money is designed to protect both buyers and sellers. In some cases, sellers are able to keep earnest money, even when the sale falls through. This usually occurs when the buyer breaks the terms of the purchase agreement. Examples include failing to hit deadlines included in the contract or pulling out because they found an alternative property they wish to purchase.
Sellers can also keep earnest money if the buyer chooses to waive the contingencies in the purchase agreement.
Tips on Protecting Your Earnest Money
As a buyer, it’s understandable to view earnest money as a temporary investment rather than funds you are essentially throwing down the well. Here are some tips to help you avoid forfeiting your earnest money:
- Pay the funds into an escrow account
The first step to take when trying to protect your funds is to pay earnest money into an escrow account. It is best to use a third-party escrow company. Avoid paying money directly to the seller.
- Make sure you are happy with the contingencies outlined in the purchase agreement
Contingencies protect buyers and sellers and provide peace of mind to both parties. Before you sign the agreement, read it carefully and make sure you are happy with the contingencies. It is critical to understand what each contingency means for you and the seller.
- Ensure that you are aware of your responsibilities
To keep your earnest money, you need to meet the requirements of the purchase agreement. Ensure that you are aware of your responsibilities, for example, meeting deadlines. If you miss those, you may end up forfeiting your deposit.
- Keep a record of all communications and agreements
For most of us, buying a house is the most significant investment we will make during our lifetimes. To protect yourself, keep a written record of the purchase agreement and any changes or adjustments to deadlines or contingencies.
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Who keeps earnest money?
Earnest money is a good faith deposit, which is usually returned to the buyer. However, the buyer can forfeit earnest money if they break the terms of the purchase agreement. If the sale goes through smoothly, the funds will be released to the buyer and put towards closing costs or the downpayment. Buyers can also keep earnest money if they walk away for reasons linked to specific contingencies outlined in the purchase agreement.
What is earnest money in law?
“What is earnest money?” is a common question asked by buyers and first-time sellers. In law, it is a payment kept in an escrow account once a seller accepts an offer from a buyer. It is often known as a good faith deposit, as it shows the seller that the buyer is serious about proceeding with their purchase.
Can earnest money be a gift?
Yes, earnest money can be a gift. If a buyer receives a gift from a relative, for example, they will need to make the lender aware and verify the deposit.
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