Are you wondering how earnest money works in a real estate transaction? When you want to make an offer on a home, an earnest money deposit will show the seller that you are serious. Earnest money in real estate provides the seller of the property with an assurance that you are committed to buying.
If you are wondering what is earnest money, or what you should do when paying this deposit, we have the answers. Let’s take a deep dive into what’s important to understand.
What is an Earnest Money Deposit?
Often referred to as a good faith deposit, earnest money is a deposit that you pay when signing a home purchase agreement. This shows the seller that you are a serious buyer and protects them when they take their home off the market.
Since the home buying process isn’t always smooth, earnest money gives the seller some compensation should the deal collapse. The seller will have costs to list their home on the market once again and find another buyer.
This earnest money deposit, which could be as much as 5% of the sale price, makes backing out of the deal expensive for the buyer unless a contingency allows it. In fact, if you are buying new construction, builders often ask for a 10% deposit.
The purchase contract will have contingencies allowing the buyer to walk away should something not go according to plan.
The whole idea of this deposit is to prevent buyers from making offers on lots of different homes simultaneously. That practice would cost sellers, who would have to relist the home when the buyer chooses one of the other properties.
Do You Always Have to Pay Earnest Money?
A seller won’t always require you to pay this deposit, but it’s unusual not to have one. If you are buying in a hot market with fewer homes than buyers, you can expect to pay this money.
Requiring buyers to pay these deposits is beneficial to the seller as it should ensure that the sale is more likely to get to closing. It will mean that the buyer can’t back out of the deal without a perfect reason if they want their deposit back.
As a buyer, you aren’t losing the money unless you want to back out without contingencies to allow you to get your deposit back. When you close on the home, this deposit will go towards your closing costs or down payment.
Common Contingencies That Protect Earnest Money
When you make an offer on a home, contingencies will protect you, allowing you to walk away from the contract with your earnest money. These will normally be set out in the purchase contract, and common contingencies include the following:
Home Inspection
If your home inspector discovers serious problems with the home, and you don’t have a contingency, you will either have to choose between losing your deposit or buying the home with its faults. While you might be able to negotiate repairs with the seller, getting them to reduce the price, you might prefer not to buy the home.
A home sale contingency allows you to get your earnest money deposit back should you choose to walk away.
Financing
Even if you have been preapproved for a mortgage, things can still go wrong with your mortgage application. Perhaps your situation has changed, and you now aren’t eligible for the mortgage you expected. If you cannot find another mortgage, this contingency gives you a way out of the situation with your deposit intact.
Home Appraisal
Mortgage lenders don’t want to lend more money to home buyers if the home is really worth significantly less than the agreed-upon purchase price. For this reason, they will want an appraiser to find the market value of the home before lending.
But if the appraiser assesses the home’s value to be less than you offered for it, you won’t get the money you need to purchase the property. This contingency will allow you to back out of the deal if you can’t renegotiate the price with the seller or cover the shortfall in financing.
In some real estate market situations, you might find yourself under pressure not to require these contingencies, but this could be a big mistake. In particular, the home inspection and appraisal contingencies are things you should hold onto even in a seller’s market.
Protecting Your Earnest Money Deposit
It would be best if you did a few things to make sure you are protected when paying an earnest money deposit. Let’s take a look:
Escrow Accounts
So that you protect yourself from possible fraud, you should make sure your deposit goes to either a real estate agent’s escrow account or title company. This third party will control the funds until they are released back to you or you get to closing.
Make sure all this money is paid directly to the trusted third party and not the seller. A certified or personal check should be made out to this third party, or you can use a wire transfer if the company allows for it.
Understanding Your Contingencies
The contingencies in the purchase agreement protect the buyer, and to a lesser degree, the seller, so both parties need to understand the details. You need to know when the buyer or the seller can walk away from the agreement, and you need to be happy with this situation.
You also need to understand what these contingencies require from you. There is often going to be a timeline that you need to stick to for having your inspection completed and other stages in the home buying process, like your mortgage contingency date. If you fail to complete these tasks when you should, you would be open to losing your earnest money.
Everything Needs to Be Put in Writing
To ensure that things are above board and you are fully protected, make sure everything is written down. This includes any changes that are made to your purchase agreement during the process, like changes to your responsibilities or the timeline. For example, if you need to get more time to get your mortgage commitment, you’ll need to get an extension from the seller in writing.
It should also be clear in the purchase agreement what happens when contingencies are triggered. The details of what should happen when the buyer wants to back out of the deal due to a contingency should be clearly stated in the agreement.
Conclusions on Earnest Money
Earnest money can seem like another expense in the already expensive process of purchasing a property, but it offers important protections to buyers and sellers. It makes sure you can exit the deal if things don’t go according to plan when you are buying and gives sellers the confidence to take their home off the market.
Hopefully, you now have a much better understanding of how earnest money works in a real estate transaction.
