What is earnest money?
Although mortgages usually account for the bulk of a home purchase, you still need to spend some money up front — and we’re not just talking about down payments. Earnest money — a deposit you give the seller once your offer’s been accepted — is one of the most overlooked costs associated with buying a house. But it’s often an important part of the homebuying journey, no matter what type of home loan you use.
The value of earnest money really comes into focus when you want to win over a seller entertaining multiple offers in a hot real estate market. At the same time, earnest money can be easily lost if you’re not careful, so it’s best to understand the ins and outs of this deposit before putting your money down. Here’s everything you need to know about earnest money.
Earnest money definition
Simply put, earnest money is a deposit, usually somewhere around 1% or 2% of the purchase price, you put down on a new home before closing. Whereas a down payment is meant to show lenders you have the funds to cover a good portion of the sale price, earnest money is focused on easing the seller’s concerns. It tells the seller that you’re making an offer on their house in good faith — hence the term, “earnest money.”
Why is earnest money necessary? When a seller takes their house off the market because they received a seemingly good offer, they’re taking a risk on that potential buyer. In the meantime, they may miss out on other offers from buyers who are more likely to secure financing and go through with the transaction. If the sale falls through, the seller needs to go through the process of relisting their home all over again. Even worse, people who put in offers earlier may have moved on to other listings, reducing the pool of potential buyers.
In perhaps the worst-case scenario, the seller might be banking on the sale of their current home to fund the purchase of a new house. If that transaction is contingent on selling their house first, any delay could cause major problems, perhaps even scuttling the deal entirely.
In short, sellers don’t have time to entertain flimsy offers or buyers who suddenly get cold feet. Putting earnest money on the table shows sellers you’re serious about buying their house.
How does earnest money work?
Earnest money isn’t required in every case, but a seller may insist upon it before agreeing to preliminary terms of a sale. Usually, the money will be held in an escrow account with the seller’s attorney or title company while other key steps in the closing process, such as the home inspection and appraisal, are conducted. If a seller suggests bypassing escrow and giving them your earnest money check directly, do not take them up on it. Escrows held by a third party offer you far more protection in the event the seller is holding back information about the house that might make you reconsider your purchase.
In most cases, earnest money is calculated based on the home’s value, although the seller may insist on a bigger deposit if they’re entertaining multiple offers or have reason to be concerned about a prospective buyer. Now, that 1% to 2% may not sound like much, but if you’re looking at house listings over $1 million, it can be a pretty significant up-front cost. And that’s before you take the down payment into account.
You or the seller can also use earnest money as a negotiating tactic. Let’s say you’re trying to buy a house in a hot market and you suspect that the house you have your eye on is going to receive a ton of offers. You can set your own offer apart by upping your earnest money and letting the seller know you mean business.
Keep in mind too that, if the sale goes through without a hitch, your earnest money isn’t a sunk cost. Those funds go into your escrow account, which then pays your monthly mortgage payments. So, assuming everything is OK, your earnest money will eventually come back to you as equity in your home.
What if things don’t work out so smoothly? We’ll get to that in just a bit.
How much earnest money should I put down?
As noted, 1% to 2% of the purchase price is pretty typical for an earnest money deposit. It really depends on your specific circumstances, though. For instance, if you and the seller don’t see eye to eye on how long the closing period should be, a change in earnest money could be included in those negotiations.
In some cases, sellers may have been burned by a buyer in the past, and they might demand a larger earnest money deposit to protect themselves from a similar situation. Also, as mentioned earlier, agreeing to put more earnest money down could make a buyer’s offer more appealing in a competitive real estate market.
Don’t feel like you have to stick to the industry standard when it comes to earnest money. View it as a potential bargaining chip when negotiating with the seller and submitting a counter proposal.
Can the seller keep my earnest money?
If everything goes smoothly, the seller wouldn’t have any real cause to hang on to your earnest money check. But if the sale falls through, on the other hand, you could wind up losing your earnest money deposit. Conditions for giving up your earnest money are typically included in your purchase contract. Always look over the terms of your purchase agreement closely so you know what to expect. Let’s take a look at a few scenarios where your earnest money could be at risk:
- You have second thoughts about buying the house
- You agreed to waive contingencies to close the deal
- You missed deadlines in your sale contract
You have second thoughts about buying the house
It’s not all that unusual to back out of a sale due to issues or concerns beyond the contingencies listed in your contract. Maybe you think you need more space or decide you aren’t in love with the location. Perhaps you’ve run the numbers through a mortgage calculator and realized you aren’t comfortable making your monthly payments even though the lender has preapproved your loan. All perfectly sound reasons to walk away from a real estate transaction, but unless they’re covered by your contract’s contingencies, you’re not getting your earnest money back.
You agreed to waive contingencies to close the deal
Sellers may pressure buyers to put aside standard contingencies like a home inspection in the interest of speeding up a transaction. In a competitive real estate market, you may just be desperate enough to agree to that idea. Be warned that if you do so, you could wind up forfeiting your earnest money even if you decide to walk away for reasons that are usually protected. Waive your appraisal contingency? Good luck getting your earnest money back after your lender refuses to extend a mortgage for a house worth markedly less than its sale price.
You missed deadlines in your sale contract
There are a lot of steps in the mortgage process, and they all need to run like clockwork. Unnecessary or excessive delays could make the seller question how serious you are about buying a house — or worse, if you can even afford to buy a house. If you fall behind on key to-do items like securing a mortgage from your lender, don’t be surprised if the seller starts to get cold feet. And in many cases, they would be well within their rights to hold onto your earnest money.
In conclusion
Earnest money deposits show sellers you’re more than just interested in buying their house — you’re committed to it. Usually, earnest money represents a small percentage of the total purchase price, but that number can go higher if used as a negotiation tactic. Homebuyers need to do their research on a house before handing over that deposit, since sales contracts often favor the seller in this regard.
Work with your real estate agent to uncover any potential issues with a piece of property early on in the homebuying journey. This way, you can avoid investing a lot of time, energy and money chasing after houses that require too much work to meet your needs.
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