How does earnest money work?

Home buying seems like a fairly straightforward process. You give the seller money, and they give you the real property. In reality, the process of selling a home is much more complicated. Money gets paid at various points and passes through several hands before you can even set foot into a new home.

One of the first exchanges of money when buying a home is the earnest money deposit, but how does earnest money work? How much are you supposed to pay? Read on to learn more about earnest money.

What is earnest money?

Earnest money is considered a “good faith” deposit on a home. It essentially tells the seller that you, the buyer, are serious about purchasing the home. Functionally, an earnest money deposit also gives the buyer more time to get things in order before closing, including:

• Preparing all their financing
• Conducting a title search
• Requesting real property appraisals and home inspections

Buying a home is extremely competitive. When you end up in a bidding war, earnest money can be that extra element that gives you a step up on the competition.

Understanding how earnest money works

Once a home seller accepts an offer on their property, they take the house off the market until the sale closes. Closing is an extended process that can take upwards of 30 to 45 days as the house goes through appraisals and inspections, and the buyer gets their financing in order. During that time when the house is off the market, the seller could potentially be missing out on other offers. By providing earnest money, you are assuring the seller that you are acting in good faith. If you back out at the last minute for any invalid reason or otherwise break the terms of the purchase agreement, the seller is allowed to keep the earnest money.

Typically, the earnest money is delivered when the buyer and seller sign the purchase agreement or sales contract, but as mentioned, it can also get attached to the offer. The exact specifications for this money can vary based on the purchase agreement, but typically, once the buyer hands over the earnest money, the funds are held in an escrow account until closing. After the buyer and seller close on the house and sign the final papers, the earnest money is applied to the down payment on the house and the final closing costs.

It is important to understand that earnest money is not an “extra” payment for the property. Earnest money still goes toward the final payment, which is why it is considered more of a deposit.

Earnest money is usually paid in the form of a personal check, certified check, or a wire transfer that is put into a trust or escrow account. That account is usually held by a legal firm, title company, or real estate brokerage until the home’s closing. Like other bank accounts, escrow accounts can potentially earn interest, meaning that the seller is required to fill out the proper tax forms if the earnest money in the escrow account builds interest.

Earnest money amount

The amount of earnest money that a buyer deposits will vary, and it is up to the buyer and seller to negotiate the exact amount. While there is no set amount, earnest money usually ranges between one percent and two percent of the home’s total purchase price. Even that can depend on the market. In hotter housing markets with higher demand, earnest money may range from five percent to 10 percent of the home’s sale price.

You will typically pay earnest money as a percentage of the sale price, but some sellers may prefer a fixed number, like a flat $5,000 or $10,000. As a buyer, you want to think of the earnest amount as a gauge of your seriousness about buying the property. The higher your earnest money deposit, the more serious your offer and the better chance of being considered by the seller.

Determining that amount can be tricky. If your earnest money is too low, the seller may not take you seriously. Too high and you risk losing money before you even move into the property. Working with the team at Berkshire Hathaway HomeServices California Properties can help you navigate the intricacies of earnest money and help you determine the best number for your earnest money deposit to optimize your chances while still working within your personal budget.

Refunding your earnest money

While the seller can potentially take your earnest money if you back out on the purchase agreement, you are also liable to a refund of the earnest money deposit based on contingencies within the sales contract.

Contingencies in a housing contract are specific conditions that must be met in order for the sale to finalize. Failure to meet these contingencies allows a buyer to back out of the deal without any penalties while receiving their earnest money back. There are various contingencies that can be included in a purchase agreement, but the most common cover the appraisal, inspection, and mortgage approval.

Appraisal contingency

Appraisals are a common part of gaining financing. A lender will usually require an appraisal to determine how much money to loan you for the mortgage. This involves a certified appraiser walking through the home, comparing the property to similar listings, and using other means of valuation to determine the home’s fair market value.

With an appraisal contingency, if the home is appraised at less than the sale price, you can potentially choose not to move forward with the sale, and you can get your earnest money back. Alternately, you can use that appraisal to negotiate a newer, lower price.

Home inspection contingency

Have you ever wondered is a home inspection required?  The simple answer is no; however, they are highly recommended, With a home inspection, a licensed home inspector goes through the property, checking all of the foundational and structural components, along with the home’s systems (HVAC, insulation, electricity). This helps to determine if the property is up to code and safe for the buyer to move into.

At the end of a home inspection, the inspector provides a report that details any defects or components in need of repair. If some significant part of the home needs repair, you are allowed to back out of the deal, no questions asked. If you still have your heart set on that property, a home inspection contingency also allows you to renegotiate with the seller. You can ask them to lower the asking price or pay for the repairs themselves before you move in.

Mortgage contingency

Most people pay their earnest money, understanding that they can get financing for the rest of the home later on. A mortgage or financing contingency ensures that you do get a mortgage before you can move on with the sale. However, if you were not preapproved for a mortgage prior to paying your earnest money deposit or if you simply do not get approved for a mortgage, a mortgage contingency protects you by allowing you to walk away from the deal with a refund on your earnest money.

Selling an existing home

Some purchase agreements include a contingency that requires you to sell your current home before you can close on another property. This prevents you from having to juggle two different properties at once. If you still have your current home before you close on the new one, you can back out of the deal with your earnest money or potentially renegotiate the terms.

Nonrefundable earnest money

In markets that are extremely competitive, some buyers may agree to a nonrefundable earnest money deposit. This means that the seller will always keep the earnest money, regardless of any contingencies. This can, of course, improve your chances of beating out the competition and closing on the deal, but it carries its own risks. Make sure you are willing to part with that earnest money in the event that the deal falls through.

Even in situations where you do have to agree to nonrefundable earnest money, you should not waive your contingencies. Appraisal and inspection contingencies can protect you and save on your investment.

Forfeiting your earnest money

When it comes to real estate it is important to ask questions. Common questions before signing a real estate contract are what are HOA fees and what do HOA fees cover? Outside of contingencies in the purchase agreement, the seller is typically allowed to keep the earnest money should the deal go awry. If you break any of the terms in a purchase agreement, like missing any contract deadlines or deciding not to buy the home despite signing the agreement, the seller can keep your earnest money.

Make sure you understand every letter of the contract or agreement to ensure that you do not accidentally forfeit your earnest money. A real estate agent or team member from Berkshire Hathaway HomeServices California Properties can walk you through the full purchase agreement before you sign the dotted line.

Earnest money can be an effective tool in showing good faith to a home seller. Earnest money is not generally a requirement for any home sale, but it does show that you are serious about the transaction. If you find a property that fits your budget and personal needs, it is absolutely worth putting down some earnest money to improve your chances of living in the home of your dreams.

Sources: Nerd Wallet, Investopedia, Rocket Mortgage, Investopedia