When it comes to buying a home, there’s usually no shortage of costs and fees that a buyer is responsible for. Closing, which should normally be an amazing moment for any home buyer, has been marred by the fear of exorbitant closing costs. Between having to come up with a down payment of 20% and having to deal with those dreaded fees due at closing, many potential home buyers tend to put off homeownership.
Still, high costs should be expected when you buying a home, especially since it’s the largest investment an average person makes in their entire lifetime. Plus, some of those fees come from services that can greatly benefit the home buyer. The key is to discuss every cost with your lender in order to determine what’s absolutely necessary and negotiate to lower any fees that can be reduced.
While some costs are not set in stone, others are unavoidable. Buying a home is not exactly a straightforward process, and not every mortgage transaction requires the same fees. As a potential home buyer, it’s good practice to be ready for any financial burdens that may pop up before, during and even after a mortgage transaction.
Delving deeper, there can also be costs that don’t really fit into the closing category. For example, many home sales have stipulations that require the buyer to provide a deposit of sorts before even making a down payment, just to enter into a purchase agreement with the seller. This kind of deposit is what is known in the industry as “earnest money”.
Sadly, not many home buyers are aware of these earnest money deposits until it is time to make one. While it may seem unreasonable at first, earnest money deposits are much more common than you would think. So just what are they?
What is Earnest Money?
Earnest money is a deposit of an agreed upon sum of money that the home buyer is requested to make in order to show that they are serious about buying a home. This sort of transaction is considered a “good faith” deposit from the home buyer and is usually used as a means of securing the seller's attention. With an earnest money deposit, the seller can rest assured that the buyer fully intends to purchase the home, and the buyer gets a little extra time to prepare for the mortgage transaction.
Good faith money, as earnest money is sometimes called, is the home buyer’s promise to the seller that they will be attempting to buy the property for sale. This escrow deposit allows the home buyer to begin with the home purchase processes of home appraisals, home inspections, title searches, etc., as well as securing financing without the worry of another buyer making a deal first. Earnest money is typically due at the signing of the sales contract or purchase agreement or submitted with an offer to the seller or their agent.
Funds from an earnest money deposit are meant to be held in the escrow account for the mortgage transaction until the closing. Once the deal is closed, the money is then added to the funds that would take care of the buyer’s down payment and closing costs.
How much of an Earnest Money Deposit is Required?
Since earnest money isn’t necessarily a requirement of a mortgage transaction, there aren’t typically any rules as to how much money is required for an earnest money deposit. In general, it’s left up to the buyer and the seller to negotiate a fair earnest money amount. Even so, earnest money deposits are usually between 1% and 2% of the purchase price.
Of course, there are still many factors in play to determine an earnest money deposit value. For example, the seller may aim for a higher number if many borrowers have shown interest in the property. Another factor that affects the requested deposit amount is how quickly a buyer can close on the deal. In more active housing markets, deposits can even reach up to 5% of the purchase price!
Still, many sellers simply ask for a set dollar amount, like $5000. Considering the amount of money that changes hands in a mortgage transaction, this amount isn’t too much to scare potential buyers away, but is usually enough for the buyer to take the deal seriously. As a seller, it’s important to not request too much or too little, as either option comes with serious drawbacks.
Why Make an Earnest Money Deposit?
During the home purchase process, when a home buyer finds a home that they are interested in, they enter into a form of contract. The contract doesn’t require that the home buyer actually purchase the home, but it does require the seller to take the property off of the market while the buyer has an interest. The problem is that while the seller is required to remove the listing (even if only temporarily) and lose the attention of any other possible buyers, the buyer who has entered the contract can change their mind at any time, particularly after having the home inspected or appraised.
As you can already imagine, this is highly unfair to the seller should the buyer decide to move on to another property after further inspection. Anyone who has sold a house before can agree that the visibility of the listing is crucial to selling a home. This is where earnest money comes into play.
While not a strict requirement of any home sale, earnest money is the solution to the problem above. Some sellers explicitly request such a deposit, and some buyers include good faith money as part of an offer. The idea is that the money is given as a way to ensure that the offer made on the property is in good faith and that the buyer is determined to purchase the property, rather than waste the seller’s time.
Earnest Money Contracts
Escrow deposits such as these are usually large sums of money. That said, it’s highly unlikely anyone would be willing to produce any funds without some sort of contract in place. Earnest money, even though it’s meant to be a gesture of “good faith,” is no different.
You see, the good faith money is supposed to ensure that the buyer is serious about purchasing the property. However, they still need to have the property appraised and inspected in order to be sure of its condition and market value. So, what happens if the results of those inquiries are less than acceptable?
Contractual stipulations to the deposit, acceptance, and refund of earnest money are always a necessity. These stipulations help the buyer get their deposit back, should the property not live up to the reasonable expectations of the buyer. Contingencies for the refund or forfeiture of the earnest money should all be clearly laid out in the contract.
For example, a buyer may make an earnest money deposit, and the following home appraisal may show a value much lower than the listed price. In addition, an inspector could discover a serious flaw with the property that would require immediate attention. In these cases, a potential buyer would typically be entitled to get a full refund of the deposited amount. This, of course, is dependent on these contingencies being stated in the contract. In general, contracts should be very detailed, and buyers should be highly aware of what the contingencies are for the return of the deposit.
The reason behind this is that the seller is entitled to keep the earnest deposit if the buyer tries to cancel the deal for any contingencies not listed in the contract. In addition, if the buyer does not meet the time limit specified in the contract, then the seller may keep the deposit as well. Lastly, should the home buyer simply change their mind and decide not to purchase the home, then they will lose their claim to the earnest money deposit.
On a brighter note, the earnest money deposit is always refunded in full to the buyer in the event that the seller cancels the deal for any given reason.
Tips for Making Earnest Money Deposits
In a mortgage transaction, the last thing any home buyer wants (or needs for that matter) is to lose any amount of money. Even for a home buyer who is determined to buy a property, there are no guarantees that it will work out as envisioned, or that the earnest money deposit will be refunded. Protecting your investment is always important, but when something as life-changing as a home purchase, it becomes a necessity.
For home buyers who must make an earnest money deposit in order to enter into a sales agreement, there are a few things to keep in mind in order to be sure that money gets returned:
Refund Contingencies - The contingencies for appraisals and inspections are often a home buyer’s only hope for getting their escrow deposit back if the property doesn’t meet certain reasonable expectations. The buyer should not agree to a contract that doesn’t include these contingencies.
Understand the Timeline - These contracts typically have set timelines that the home buyer is expected to adhere to. Whether it is a deadline for inspections or appraisals or even a deadline for finding and securing financing to purchase the home, not meeting the specified deadlines is typically grounds for forfeiting the deposit.
Be Vigilant About who Handles the Money - This is crucial. Make sure you research the party that will be holding the money in escrow. Be sure that the deposit is never given to the seller directly. The third party in charge of the escrow account should be reputable and relatively well known. Home buyers are urged to always get a receipt for any transaction involving the deposit.
Earnest Money: In Review
The average home buyer isn’t made of money. Still, there are endless things that require out of pocket payments that pop up when shopping for a new home. One such cost is the often requested earnest money deposit.
Earnest money deposits play an important role when a home buyer enters into a sales contract with a seller. An earnest money deposit is a sum of money deposited into an escrow account that serves to show the seller that the buyer is serious about purchasing the property. It’s also known as good faith money.
Earnest money deposits help the seller feel a little more secure in having their property off the market while the buyer goes through with the process of getting the property appraised, getting a home inspection, and even securing financing. If all is well, the money is added to the amount that would become the down payment and/or the funds towards paying some of the closing costs. If the home doesn’t meet expectations, then that money is returned to the home buyer (as long as the contract allows for a refund if the home buyer decides to cancel the deal).
Conversely, if the home buyer were to try to back out of the deal for no particular reason, or any reason not listed in the sales contract, the money is granted to the seller. Think of earnest money deposits as a way to keep things fair between buyers and sellers. If you still want to learn more about earnest money deposits, call a home.loans mortgage specialist today!