Earnest Money in Real Estate and How to Protect Your Money

For first time buyers or sellers, hearing the term earnest money may cause some confusion, and you may wonder what exactly it means.

What is Earnest Money in Real estate?

Earnest money, or an earnest payment, in real estate is a certain type of security deposit made to a seller that represents the good faith of a buyer, in that they will commit to buying a home or property.

Essentially this deposit gives the buyer a bit of extra time to source financing, complete inspections of the property, and conduct a property appraisal and title search, plus more.

Other common terms include escrow deposit, good faith money or simply a house deposit.

A contract is usually drawn up when the two parties are exchanging the earnest money, it will outline important factors and conditions for refunding the amount if the need were to arise.

The contract does not obligate the buyer to go through with the purchase, as after an inspection has been completed on a property a problem could be flagged that deters the buyer from wanting to go ahead with the purchase.

This contract does however ensure that the seller removes their house from the market so other buyers are not able to place an offer.

How much should the earnest money deposit be?

Typically, you can expect an earnest money deposit to be anywhere in the region of 1-10% of the sale price of a house or property.

It will generally be influenced by market interest.

There are some occasions where a small payment of $1000 will do, but this depends on the seller’s choice.

Is earnest money refundable?

In short yes, earnest money is refundable, but only if certain conditions are met.

If a buyer happened to cancel a contract during the option fee, then the money would be returned to them.

However, if the contract is cancelled after this period, the money cannot usually be refunded to the buyer.

Earnest Money Definition

Earnest money is the sum of money exchanged from a buyer to a seller, in the form of a deposit, that represents the good faith of a buyer to go through with the purchase of the seller’s home.

Earnest money how much is required?

The amount of earnest money required depends on a few factors.

Generally, a buyer will try to secure a lower earnest money deposit, this is just in case they need to pull out of a sale due to any issues flagged in an inspection.

Sellers on the other hand will try to ensure the deposit is larger.

In a market favoring buyers, where sales are slow, it is often possible to secure a smaller deposit as you will likely be the only offer. However, in a market favoring sellers, they will likely be able to secure a larger deposit from the buyer.

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In a market or neighborhood where bidding wars often occur and houses are not for sale for long, it is considered a good idea to offer a higher earnest money deposit to help with securing the property.

If you are utilizing a real estate agent you will be able to obtain additional advice and guidance from them on how much earnest money to offer.

They will generally recommend that you do not undercut an earnest money deposit amount as you would likely lose the property to a stronger offer from a different buyer.

Who gets the earnest money?

The earnest money must always be sent to a trusted third party, for example a law firm, escrow company, or real estate brokerage.

You must also always ensure you obtain and keep hold of a copy of the check and receipt for your records.

There have been extremely unfortunate cases in home buying where buyers have lost their earnest money deposits to fraudulent individuals or companies who pose as agents or sellers.

For this reason, you should never give your hard-earned money to any individuals.

When is earnest money due?

Generally, the earnest money is due and delivered when the sales contract has been signed and accepted by the seller or shortly afterwards, but it can sometimes also be attached to the offer. When the money has been deposited by the buyer it will usually be held in an escrow account of a third party of their choosing until closing and finalizing. The deposit is then applied to the down payment of the property and closing costs of the buyer. It is essential for buyers to have the funds for an earnest money deposit in their checking account, before they begin to put offers down on homes or property.

When can a seller keep the earnest money?

A buyer pays earnest money as a good faith deposit that essentially confirms to the seller that they wish to go through with the purchase of a house. However sometimes instances can occur that may cause the buyer to withdraw and pull out of the sale agreement.

If this happens during the option period, then it is likely that the buyer will be able to claim a refund on the earnest money deposit.

If a buyer’s financials fall through, they wish to renegotiate or even feel remorseful about a sale and contract, then it is likely a seller will retain the earnest money deposit.

Generally, it is kept as compensation for the time that their house or property has spent off the market when the earnest money deposit was made, causing them to miss out on other possible sale opportunities and offers.

A few tips to consider using as a seller to protect yourself are…

Cash the earnest money deposit check.

The money will stay within the escrow account of the third party, however if your agent cashed the check it will stop the check bouncing if the buyer attempts to remove the money out of the account if the sale falls apart.

You should know exactly who is holding the earnest money deposit.

If the buyer has not sent the money to the seller’s real estate broker it could be being held by a third party title, bank or law firm. It is important to know where it is being held.

Make sure you know your contingencies.

Buyers will usually set up contingencies to protect themselves and their money if for any reason they need to back out of and withdraw from a sale.

A seller must thoroughly check and make themselves aware of any case where a buyer may be overly protecting themselves with contingencies, for example if they get cold feet and want to pull out, especially in a crowded and popular market.

How to show proof of earnest money deposit?

It is quite a common occurrence for sellers to ask for proof of a buyer’s funds, when they are purchasing a house or property from them, particularly if the buyer is a cash buyer.

A seller may wish to confirm that the buyer actually has the down payment and closing costs, before they agree to the sale contract with a buyer. This protects them from wasting time on a buyer who is not serious, or where a sale is likely to fall through.

Cash buyers are those who have cash readily available to close and purchase the house or property outright. As they are using cash they will not require or rely on a loan or mortgage from a bank.

Some buyers believe themselves to be cash buyers when in fact they can sometimes be mistaken.

For example, they may be borrowing money from a parent or relative, waiting for a probate court to release assets or perhaps in the process of selling stocks.

Put simply, if their money is not readily available in their checking account, a buyer cannot consider themselves a cash buyer. There have been cases of deception where a buyer using a cash loan presents themselves as a cash buyer, this act could violate the law.

When requesting proof of funds from a buyer it is recommended that the seller acquires the following information: Date, the balance of funds and the account holders name.

This is usually preferred on documentation in the form of a letterhead that bears the information and branding of the company where the funds are being held.

For example, a bank statement, certified financial statements, or an open equity line of credit.

Whether a cash buyer or not, the process remains the same, it is important that the seller obtains this information.

How to protect your earnest money?

It is possible to protect your earnest money as a buyer. To do this you should ensure you include a timeframe in the contract in which you have time to cancel the sale and keep hold of the earnest money deposit.

This is known as an option period. In order for a sales contract to be considered valid, any and all real estate contingencies must be met.

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As an example, a buyer may use a financing contingency that allows them to cancel a contract legally if their financing happens to fall through.

Examples of contingencies to consider are listed below.

Financing

This type of contingency states that the final agreement is contingent on approval of the buyer’s mortgage. If a loan happens to be denied for any reason, the buyer should be able to claim back their earnest money deposit.

Home inspection

This type of contingency will protect a buyer’s earnest deposit money in the instance that any repairs, damage or faults are found on the sellers property, for example a damaged roof, leaking pipes, damp and mold or faulty wiring that isn’t up to code.

If any repairs need to be done a buyer can ask that a seller carries these out and pays for them prior to closing.

Title and Deed

The property deed, or home title, is a document that states the legal owner of a house or property. It is possible for a buyer to run a check with a title company to ensure that the seller actually has the legal right to sell the home.

Selling current home first

Many buyers will face the issue of not being able to qualify for a mortgage until they have sold their current home. This type of contingency will protect a buyer in this instance.

If a buyer struggles to sell their current home and cannot obtain a mortgage and complete a sale, it is possible for them to back out of the contract and claim back their earnest money deposit.

It is common for sellers to disapprove of this type of contingency because of how common it is likely to occur. It is possible that it will lower the chances of a buyer’s home offer being accepted.

Home appraisal contingency

This type of contingency is what many lenders will use to help them to determine the actual market value of a home.

If an appraisal returns and it is lower than that of the agreed upon purchase price of the home or property, then a buyer can choose to renegotiate on the asking price or withdraw from the contract fully.

If these contingencies are fulfilled and the buyer still does not close and complete the sale, the seller would be entitled to keep the earnest money deposit of the buyer.

The contract is legally binding.

It is recommended that both the buyer and seller keep a close eye on the timeframes of the contingencies.

If either the buyer or seller fail to complete their required action within this set timeframe, they will have defaulted.

For example, a buyer may have 20 days to complete their proposed inspection of the sellers home or property, if they fail to meet this timeframe the seller will be able to keep the buyers earnest money deposit.

Many sellers may choose to add a “time is of the essence” clause into the contract agreement. Essentially what this means is that the closing date added into the contract is binding.

If the buyer is not able to close by this date, for any reason, the contract will have been breached and the seller will keep the buyers earnest money deposit.

The Earnest Money Bottom Line

Earnest money is like another extra cost you need to cover. However, it is very important. The reason behind it is that if something’s wrong with the property.

It also protects the seller if you like out the deal and this proves to the seller that you are serious about your offer.