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What is Earnest Money?

definition

Earnest money is a deposit that a buyer puts down as a deposit to the seller at the time of entering into a contract for a large purchase, often used in the sale of a house.

🤔 Understanding earnest money

Earnest money, which is often referred to as a good faith deposit, is money that the buyer puts down to show the seller that they are serious about their offer to buy a large asset such as a home. When a seller accepts an offer on their home, they agree not to entertain other offers. If the deal falls through, it creates an added cost and inconvenience for the seller. This earnest money deposit gives the seller confidence that the buyer is not going to back out. If the deal falls through for a reason outside the buyer’s control (such as a failed home inspection), the buyer can usually get their money back. But otherwise, the earnest money is the buyer’s way of putting their money where their mouth is.

example

Let’s say Chris is shopping for a home and has made an offer to buy Janet’s house for $250,000. As one of the stipulations of accepting the offer, Janet has asked Chris to put down 2% in earnest money, which is a total of $5,000. This money goes into an escrow account, where it sits until the sale of the house closes. Chris isn’t out his $5,000 after the sale closes — That money can go toward the purchase price of the home.

Takeaway

Earnest money is like putting down your credit card number to reserve a table at an exclusive restaurant…

The restaurant wants to know you’re serious about showing up because holding the table for a no-show would cost them the opportunity to seat another party. If you flake, they’ll charge you a fee. Similarly, the seller of a house or other large asset wants you to show that your purchase offer is serious — And they want a little compensation if you change your mind after the offer’s been accepted.

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Tell me more...

How does earnest money work?
Do I get my earnest money back?
What do I need to know about earnest money before buying a house?

How does earnest money work?

An earnest money deposit (EMD) is paid by the buyer of a house (or other large purchase like a business). But that money isn’t going to the seller. Instead, the earnest money, usually paid by wire transfer or check, goes into an escrow account opened by a third-party broker or title company. The money is typically deposited at the time when the home purchase agreement is signed.

The amount you’ll need for earnest money can vary, but it’s usually between 1% and 5% of the sale price of the home. So, if you’re purchasing a $300,000 home, the earnest money would be somewhere between $3,000 and $15,000. In areas with booming housing markets, the percentage might be even higher. In some cases, the buyer might also ask for a fixed amount, such as $1,000 or $5,000, rather than a percentage of the sale price.

The amount of earnest money required can be negotiated between the buyer and seller. But in general, the more earnest money you offer as a buyer, the more serious you’re showing the seller you are about your offer.

Earnest money isn’t necessarily required. That is, there’s no requirement from mortgage lenders or from the law that states you must put down an earnest money deposit. But in many cases, the seller might require it. If a house sale falls through, it can cost the seller both time and money. They want to make sure they’re accepting an offer from someone serious about buying. So in the case of a competitive housing market, you’ll most likely have to put down earnest money as the buyer.

Do I get my earnest money back?

Once you pay your earnest money, that money is not gone forever. It doesn’t go to the seller unless you back out of the sale. Instead, if everything goes as planned and the sale of the house closes according to the scheduled timeline, then the earnest money goes toward either the closing costs or the purchase price.

It’s important to note that there are situations where you could lose your earnest money. If you have a change of heart and decide not to buy the house, you’ll most likely end up losing your earnest money.

There might be situations where an incident in your personal life necessitates walking away from the sale. Perhaps you planned to buy the house with a significant other, and you’ve broken up. Or maybe you’ve lost your job and no longer feel confident about your ability to make the mortgage payments. In those situations, even though you’re losing money, giving up your earnest money might be the best choice.

Most contracts will include contingencies that protect the buyer and list the situations in which a buyer could back out of the sale without losing their money. Some common contingencies are:

  • Home inspection: It’s common to have a contingency in the purchase contract for a failed home inspection. This means if the inspection happens, and it turns out the house needs a lot of repairs that the seller isn’t willing to make, you can get your earnest money back.

  • Appraisal: Sometimes, you have the house appraised, and it turns out the home isn’t worth what you were planning to pay for it. If the seller isn’t willing to lower the price, you might want to walk away from the sale. As long as this clause is in your contract, you can get your earnest money back in this scenario.

  • Financing: If for some reason you can’t get financing for the home, then you might have to back out of the sale. This might happen if you didn’t get preapproved or your financial situation drastically changed and you find out you can’t get approved. It also might happen if the appraisal doesn’t go well –- A low appraisal might also impact your ability to get financing, as a lender may not want to lend more than the house is worth.

  • Sale of another home: It’s not uncommon to have a situation where a family is selling their home and buying a new home at the same time. When this is the case, it’s common for the contract to include a contingency that allows the buyer to back out and get their earnest money back if they can’t sell their other home.

What do I need to know about earnest money before buying a house?

The process of buying a home can be confusing, especially the first time around. You might find yourself going into the process not entirely sure what to expect, and so it’s easy to make mistakes. Let’s talk about a few things you should know about earnest money before going in, so you don’t end up losing money.

Make sure you understand what earnest money is

If you haven’t done your homework ahead of time, the idea of earnest money might come as a surprise to you. In some cases, an unaware buyer might even find themselves unable to afford the earnest money. In most cases, it’s only between 1% and 5% of the purchase price. But in areas where the housing market is booming, it could be higher, and unprepared home buyers might be caught off guard.

Don’t offer too much or too little earnest money

The real estate market you’re in will largely determine how much earnest money you should offer to put down. Offering too little might turn off the sellers and cause them to choose a different buyer. Offering too much might put you in financial jeopardy down the road if the sale falls through. Your real estate agent can usually advise you on the appropriate amount to offer.

Include contingencies in the contract

Your contract should include contingencies that lay out what situations allow you to get your money back if the sale of the house falls through. Some of these contingencies include problems with the inspection or appraisal. It’s in the best interest of the buyer to have as many contingencies in the contract as possible. Be very careful about agreeing to remove contingencies from the contract, because if the sale falls through for any reason not protected in the agreement, you’ll lose your earnest money.

Use an escrow account

You should never pay your earnest money directly to the seller. Make your deposit with a reputable third-party broker, escrow company, or title company. Verify the money is going into an escrow account, and get the paperwork to prove it. Pay attention to contract timelines

The contract you and the seller sign will usually include a timeline that must be followed, including a closing date. If these deadlines aren’t followed, you might lose both your earnest money and the opportunity to buy the house.

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