Earnest money is a deposit that may be required of a buyer in connection with buying a home. This deposit is made during the home buying process to prove the buyer's interest and good faith in purchasing the home.
What Is Earnest Money?
Generally, the earnest money deposit is made at the time the buyer signs the purchase agreement to buy the house. This deposit allows the buyer time to secure their financing and to have things like the home inspection performed. The earnest money deposit is held in escrow until the purchase is finalized and is then applied to the buyer's down payment. The escrow account is normally held with the seller's broker, the title company or with an escrow company.
The contract doesn't completely obligate the buyer to purchase the home - it will still have to pass an inspection conducted for the buyer and an appraisal that could impact the buyer's financing. The seller does take the home off the market while the inspection and appraisals are being performed, the earnest money deposit compensates them for doing so.
However, if the buyer backs out of the deal because they've had a change of heart, or for reasons not covered by any of the contingencies that allow them to do so under the terms of the contract, the buyer will generally forfeit their earnest money deposit.
Earnest money is sometimes also referred to as an escrow deposit or good faith money.
How Much Earnest Money Do You Need?
The amount of earnest money required will be determined by the seller, generally in consultation with their listing real estate agent. Amounts typically range from 1% to 5% of the purchase price. Sometimes the amount is a fixed dollar amount. The amount of earnest money is a function of what the seller asks for, as well as the size of the transaction and the demand housing in your area.
In some ultra-high cost, high-demand housing markets, there may be times where the buyer can afford the house but not the cash needed for the earnest money deposit.
How to Protect Your Earnest Deposit
It's important for a prospective buyer to understand how their earnest money deposit is handled and all of the terms and conditions associated with this deposit. If you don't understand, ask questions and don't write the check until you are 100% clear about all terms surrounding this deposit.
You will want to take some precautions associated with handing over your earnest money check, including:
- Don't give the check to or make it payable to the seller.
- Make sure the check is payable to and deposited with a reputable real estate brokerage firm, a trust company, escrow company or a lawyer.
- Be sure to verify that the recipient of the earnest money deposit will keep that money in a separate trust account for that purpose.
- Obtain a receipt or other documentation for your earnest money deposit.
- Avoid authorizing the disbursement of the earnest money until the transaction is finalized.
Some additional things you can do to protect your earnest money include:
- Ensure that contingencies for obtaining financing and for the property passing an inspection are included in the contract. Also make sure that the contract specifies that your earnest money will be refunded if you are unable to get financing or there is a serious problem with the home that is uncovered during the inspection.
- Make sure that you read and abide by the terms of the contract. For example, if the contract specifies that the home inspection be completed by a certain date, be sure that it is completed by that date. Failure to abide by terms such as this could result in the loss of your earnest money and the house as well.
Is Earnest Money Refundable?
The laws governing earnest money deposits will vary by state, including when these deposits are refundable and when the seller does not have to refund your deposit. It's also important that you read the contract regarding the handling of earnest money, and again under what circumstances it may or may not be refundable if the deal falls through.
Typical contract contingencies whereby earnest money might be refundable include:
- The buyer isn't able to obtain financing for reasons beyond their control.
- The appraisal comes up short of the home's estimated value.
- The buyer is unable to sell their current home first. This has been a pretty common contingency in the past, sellers may not be willing to include this in "hot" real estate markets.
- The home doesn't pass an inspection that is paid for by the buyer. This is a common contingency that protects the buyer from purchasing a home with a serious defect that may not be apparent while walking through the home during the sales process with a real estate agent.
- Absence of a clear title. A title company will be engaged to ensure that the seller has clear title to the home and that they have a legal right to sell the home in the first place. As you might imagine, buying a home without this verification could turn into a nightmare for a buyer.
When entering into a contract to purchase a home it's a good idea to engage the services of a knowledgeable real estate attorney to read the contract and to ensure that there are proper contingencies that allow you to back out of the deal and to recoup your earnest money if these contingencies are not met.
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