You're not alone if you're confused by real estate jargon. Technical terms like earnest money, option fee, down payment, escrow, and closing may feel intimidating to the first-time home buyer.
Learning these terms helps avoid misunderstandings during the home purchase agreement. What follows here is everything you need to know about earnest money and an earnest money deposit.
What Is Earnest Money?
Earnest money is used while buying and selling a house. It is the sum of money the buyer deposits to get into a purchase agreement with the seller. It is also called a “good faith deposit.”
Home purchase starts with an offer, usually arranged through the buyer and seller's real estate brokers. Once the seller is comfortable with the offer, the two parties go into a purchase contract. The buyer submits a sum of money – the earnest money – as part of the signing deposit. Amounts can vary, but they are typically around 1% to 2% of the total value of the property.
After the two parties enter the contract, the seller takes the property off the market for any new offer. House closing takes time through inspection, appraisal, and funding. Therefore, the earnest money is compensation for the risk if the deal falls through.
What Role Does Earnest Money Play?
Earnest money essentially works as an assurance to the seller for his consideration of the buyer's offer. It demonstrates the buyer is serious about following through with the deal and shows they are a strong candidate for buying the home.
The earnest money is usually not mandatory, but it plays a vital role in the sellers' market. It is due within three days after the effective date of the purchase agreement. If you are buying a home and have a real estate agent, they'll guide you through the process and help deliver your check.
A third-party agent, either a title company or an escrow account, will hold the earnest money until closing. It ensures that the party entitled to the cash gets it quickly if and when the deal falls apart.
Is Earnest Money Required?
Technically, you can get into the purchase contract without issuing earnest money. Also, it is not a requirement to get into a purchase agreement to buy a house.
However, you'll be in default if you don't deposit the earnest money within the time frame specified in the contract. In such cases, the seller can terminate the agreement.
How Much Earnest Money Should You Put Down?
There is no set rule for the earnest money amount. The amount is highly negotiable, and often depends on whether it is a buyer's market or a seller's market at the time. Typically, it's about 1% to 3% of the sale price.
It is in a seller's best interest to sell their property as soon as possible and get money. As a buyer, the one way to show that the deal will not fall through due to funding issues is through the speedy delivery of earnest money. The amount also indicates if the potential buyer has liquid funds to make a purchase.
Does Earnest Money Go Towards Down Payment?
The earnest money goes to the down payment and closing cost when the deal goes through. The money stays at escrow or title company until the closing date. Therefore, you can assume it is part of the down payment.
Who Gets Earnest Money if the Deal Falls Through?
If the contract falls through, it is not always clear who will receive the earnest money. It depends on who caused the deal to falter. If the cash is released before closing, or if either side does not follow the contract, things can get tricky. That's why a third party holds the money through that stage.
If the home appraisal comes back low, the financing agency or lender (banks or financial institutions) will only fund up to the appraised value (minus down payment). The seller will have to arrange for additional cash, or else they can't close the house. In this case, the buyer is not at fault; therefore, the buyer claims the earnest money.
In another situation where the buyer backs out of the contract for no reason, they will be in default. The seller can terminate the agreement and receive the earnest money as liquidated damages. Similarly, the buyer gets the earnest money if the seller backs out of the deal.
Earnest money is refundable if the buyer follows the contract, and it is not their fault that the deal falls through. The agreement has many stages where the buyer gets their money back without disputing the contract.
Can Seller Refuse the Release of Earnest Money?
The seller can refuse to release the earnest money if there is a dispute on who is at fault for the deal's fallout. Since a third party holds the money, buyers do not have access to it.
The title company will not release earnest money until the two parties come to a common conclusion in writing and terminate the contract.
How To Pay Earnest Money?
Earnest money can be paid via various channels, such as personal checks, bank checks, cashier's checks, or wire transfers. Since a timely transfer is ideal, most people prefer to drop off the check or go for a wire transfer for speedy delivery.
If you can't pay by check, a money order is acceptable.
Cash is not acceptable as payment for earnest money. Both parties want to have a paper trail to keep track of the earnest money payment. Lenders often verify that the amount is coming out of your bank account. The lender can disallow unverifiable deposits from being included in closing costs.
Credit cards are also not an acceptable payment method for earnest money. Earnest money and down payment can't be borrowed funds because they are unsecured debt.
How To Write a Check for Earnest Money?
Writing a check for earnest money is no different than for any other purpose. However, there are a few things you'd want to keep in mind.
The check goes to the closing agent, which, in most cases, is a title company. Therefore, the title company's name should be in the blank section for “Pay to the Order of _____ .” It is beneficial to add the description under the memo as “earnest money for [address of the property].”
The buyer will get an earnest money receipt after the title company receives the payment.
Earnest Money Deposit vs. Down Payment
The earnest money acts more like a buyer's commitment toward the home purchase, and the title company holds the fund. In contrast, a down payment is a set amount promised to the mortgage lender for securing the financing.
You don't need to issue the down payment until the closing day. The earnest money must be given within the set date in the contract after it is signed and before closing.
Option Money vs. Earnest Money
Although it's not a legally binding requirement, the option fee is an amount the buyer pays to get an option period (mostly ten days) for the house inspection. He can walk out of the deal should the home inspection determine significant repairs or improvements required. The option amount is relatively small, ranging from $200 to $500. It is usually non-refundable but must be included in the contract if it goes towards the closing.
Unlike option money or fees, earnest money does not give you any time frame to walk out of the deal. Option money protects the buyer from getting too tied up in the homeownership decision process, while earnest money protects the seller if the buyer walks away simply because he changed his mind.
Earnest money is one of the essential aspects of the home purchase process. The money ties the buyer's seriousness to the seller's assurance. As a buyer, you can get an earnest money refund if issues are found during the inspection, low appraisal, or home financing. You can claim this money as a home seller if the buyer is at fault.
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Ram is an Engineer by day and a personal finance blogger by night. He shares his tips and tricks on earning, saving, and growing money through his blog, Dollar for Cent. He uses his analytical and problem-solving skills to tackle money problems, find deals, and increase wealth. He loves his day job but believes our lives should not be location-bound and time-constrained. He documents his financial journey and hopes to reach financial freedom.