When a buyer purchases real property, she’ll typically offer deposit money to be held in escrow to indicate that she’s sincere and that she intends to go through with the purchase process. This is fittingly referred to as “earnest money.” The word “earnest” is a synonym for “sincere.”
Offer a lot of it, and you’ll get the seller’s attention. Offer just a little, and the seller isn’t likely to take you very seriously.
The last thing any home buyer ever wants to do is put down money to buy a home and lose it, but it happens. There are many ways to lose your earnest money deposit. If you don’t understand how your deposit is handled, you should ask questions at the time you make an offer. Ask to see the verbiage in the contract that guarantees the return of your deposit. Not every purchase contract affords this type of protection.
Earnest money is a deposit a buyer gives to a home seller to show that the buyer is serious about purchasing the property.
Definition and Examples of Earnest Money
Earnest money is a deposit you’ll make when you make an offer on a home. This is meant to show the seller that you’re serious about purchasing their property. And although earnest money isn’t necessarily a mandated part of a home offer, it is common enough in the United States that you’ll find it in nearly all real estate transactions.
The amount of earnest money you’ll offer depends on the seller; they may decide that they require a specific percentage of the list price or just a flat amount. Deposits of 1% to 2% of the purchase price are common.1 Depending on how the sale goes through—or doesn’t—earnest money will be distributed to the buyer, the seller, or back to you.
* Earnest money shows the seller a buyer’s intention to purchase their home.
* Earnest money is also called a good-faith deposit.
An effective agreement is a legal arrangement between a potential purchaser and the property’s seller.
Some important tips to keep in mind to streamline the process:
* Keep written records of everything. For the sake of clarity, it will be extremely useful to transcribe all verbal agreements including counter-offers and addendums and to convert them into written agreements to be signed by both parties. We will assist you in drafting all the paperwork for your purchase and make sure that you have copies of everything.
* Stick to the schedule. Now that you have chosen your offer, you and the seller will be given a timeline to mark every stage in the process of closing the real estate contract. Meeting the requirements on time ensures a smoother flow of negotiations so that each party involved is not in breach of their agreements. During the process, we will keep you constantly updated, so you will always be prepared for the next step.
Earnest money usually accompanies an offer to purchase a home. This money is meant to show the seller that you’re genuinely interested in buying their property regardless of any contingencies you place on your offer. And unless you’re making an all-cash offer to purchase the house as-is, you will likely have contingencies built into your offer.
Common contingencies include selling your own home, securing financing, and successfully completing a satisfactory home inspection. Depending on how your contract moves forward, either you or the home seller will receive the earnest money. If you fail to follow through on your end of the bargain, that money may be forfeited to the seller. Let’s look at an example.
Let’s say you’ve made an offer on a home contingent upon a satisfactory home inspection and the seller accepts your offer. You have your financing, the home inspection goes off without a hitch, and you’re well on your way to closing when another home pops up on the market. It’s your dream home, and you can’t bear letting it slip through your fingers.
Note
Make sure you know who is holding your deposit—it could be your broker, the seller’s broker, or even a third party, such as a bank or the escrow company that’s handling the transaction.
If you choose to back out of the contract for a reason that isn’t covered by your contingency—like failing the home inspection—the earnest money you’ve deposited will be distributed to the seller. In this case, a better home is not a good reason to cancel the contract and your good-faith deposit will be forfeited.
But what if this is your dream home and something goes wrong?
Let’s say the home inspection report indicates that the home’s foundation is cracked. As long as the deadline written in the contract for your inspection hasn’t passed, you have a few options. You can negotiate to have the seller repair the foundation or credit you the cost of the repair, or you can choose to back out of purchasing the home. Since the contingency covers a satisfactory home inspection, you are backing out of the purchase contract due to no fault of your own, and your earnest money is returned to you.
As long as things go according to plan, if you choose to leave the contract because of a covered contingency, the seller will sign the release of the earnest money deposit so that you can receive your funds. However, sometimes there will be disagreements and the seller can refuse to sign the required paperwork. In this case, the dispute will have to be settled in court.
But if the home inspection goes well, you secure your financing, and the home purchase moves ahead, earnest money is usually distributed according to your direction. You can choose to have it put toward the purchase price of the home or even have it disbursed back to you.
Key Takeaways
* Earnest money almost always accompanies an offer on a home.
* The earnest money deposit illustrates to the seller that you’re willing and able to purchase the property.
* If the home sale falls through, disbursement of the earnest money depends on your contract—it can go to either you or the seller.
* When the home closes, you can choose how you want your earnest money distributed.
Typically, there is no set deposit requirement. In California, for instance, contracts must contain consideration to be valid, but that amount can be as little as one dollar. Laws in your state may be different. Bear in mind, however, that the amount of your earnest money deposit depends primarily on your marketplace and local custom.
Consider this: If you offered a seller a $1.00 as an earnest money, the seller would look at you funny and presume you are not serious. Earnest money should reflect your earnest intention to make good on your offer and purchase the home.
Earnest money is a good faith deposit that is part of the down payment but should not to be confused with a down payment. When buyers execute a purchase contract, the contract specifies how much money the buyer is initially putting up to secure the contract, to show “good faith,” and how much money all together will be deposited as a down payment. The balance is generally financed as a mortgage or a combination of mortgages. An earnest money deposit says to the seller, “Yes, I am serious enough about buying your house that I’m willing to put my money where my mouth is.”
Because there is no set amount, it varies from market to market and across the country. In California, for example, deposits are generally 1 to 3 percent of the sales price. Buyers here do not often put down more than 3 percent since most sign a liquidated damages clause that limits the seller to 3 percent of the purchase price as damages in the event of a default. Although, it is unusual for a buyer purchasing a $300,000 home to put down $1,000, especially if the buyer is obtaining 100% financing, like a VA loan.
In those scenarios, the deposit is most often refunded to the buyer and subsequently used as a credit toward closing costs because the financing makes up the entire purchase price.
Some recent legislation has put agents on the alert that the listing agent might not be protecting the seller if she does not advise the seller to ask for a larger earnest money deposit. This could arise in the event the buyer defaulted. A court might question why the earnest money was so low and blame the listing agent.
If it’s a seller’s market, with many buyers fighting over limited inventory, it makes logical sense for the buyer to put down a much larger earnest money deposit to entice the seller to accept the offer. In buyer’s markets, a larger earnest money deposit might entice a seller to accept a much lower purchase price. It is often the market and local conditions that can determine the amount.
When making an offer and submitting your earnest money deposit, it pays to be informed. While issues are rare, ensure you know to whom you’re giving the deposit and keep the following tips in mind:
* Never give an earnest money deposit directly to the seller.
* Make the deposit payable to a reputable third party such as a well known and established real estate brokerage, legal firm, escrow company, or title company.
* Verify that the third party will deposit the funds into a separately maintained trust account.
* Obtain a receipt.
* It is generally inadvisable to authorize a release of your earnest money (or a pass-through) until your transaction closes.
First, read your contract. Laws vary from state to state. In California, for example, standard C.A.R. purchase contracts allow for the return of the earnest money depositto the buyer within a specified time period should the buyer elect to cancel the transaction. If at that point the seller refused to return the deposit without cause, the seller could end up paying a $1,000 civil penalty to the buyer.
However, not every agent is a member of C.A.R. in California. And builders typically do not use a C.A.R. contract as they have their own purchase contracts.
In usual circumstances, though, upon cancellation, the sellers and buyers are asked to sign mutual release instructions. If an agreement cannot be reached, the party holding the earnest money deposit will continue to hold it until an agreement is reached. If no agreement has been reached after a few years, escrow companies then send the parties a certified letter asking for mutual instructions. The letter says if nobody responds within a certain time period, then escrow will return the money to the buyer.
If the seller contests the action then, after three years, escrow will send the money to the state of California.
The concept of earnest money rests on the premise that a contract is not an ironclad obligation for the buyer to purchase the property in question. A lot can go wrong between making an offer and closing. Home inspections can turn up deal-breaking flaws. Appraisals can come in startlingly low. In these cases, the buyer might be entitled to take his earnest money back, or at least reclaim a portion of it.
When a seller accepts an offer to purchase, she is contractually bound to take the property off the market for a period of time while contingencies like inspections and appraisals are taken care of. She needs some sense of security that the deal will go through.
Most states have very strict rules regarding the handling of and accounting for earnest money deposits. The money is usually held in an escrow company account, a title company account, the buyer’s broker’s trust account, or the seller’s broker’s trust account. Both the buyer and the seller have a legal right to the money once it’s deposited.
That said, the money is ultimately used to offset the buyer’s costs in the transaction at the end of the day. It appears as a credit on the settlement statement, so it reverts to being her money at that point.
The disposition of earnest money in a dispute and in the event of a failed transaction is also spelled out in state law and in real estate regulations.
In many real estate contracts, the buyer and seller agree to mediate before going to court and taking further legal action. Mediation usually results in an agreement by the parties as to how the earnest money will be distributed in a failed deal. In many cases, just avoiding the cost of mediation will result in an agreement between the parties.
As a general rule, however, the deposit is typically forfeited if the buyer doesn’t perform under the terms of the contract, such as having the property appraised in a timely manner or if he simply gets cold feet and wants to cancel the contract.
Everyone involved in a real estate transaction should be familiar with his state’s rules regarding the handling of earnest money, particularly in the event of a failed transaction.
Remember, an escrow account is no different from your personal bank account when it comes to paying interest. For the most part, any interest earned should be negligible because the money won’t be on deposit for an extended period of time. Even so, that interest is taxable to the buyer as income.
The buyer would have to file Form W-9 with the Internal Revenue Service to claim that interest should the deal drag out forever and the account earn more than $5,000.