When you purchase a home for the first time, there will probably be a few things you didn’t realize. One of those potential items is the need to put up a security deposit.
It is referred to as an earnest money deposit in real estate circles. Understanding earnest money deposits in real estate is essential for buyers and sellers. It’s one of the most important steps to buying a home, and one of the more crucial aspects is knowing how much earnest money is appropriate to collect.
We will take an in-depth look at what you need to know about earnest money deposits in real estate. Let’s dig in.
What is Earnest Money?
Earnest money is a good faith deposit made by a potential buyer to demonstrate their commitment to purchasing a property.
It is usually a percentage of the purchase price and is held in an escrow account by the seller’s real estate agent or attorney until the closing. The seller can retain the earnest money if the buyer does not follow the contract terms.
The earnest money deposit will be credited to the buyer at closing when the transaction is successful.
How Much is Earnest Money?
The amount of the earnest money deposit is typically negotiated between the buyer and seller. The amount of earnest money can vary in different locations around the U.S.
You can expect the amount to be between 1-5% of the purchase price. The earnest money deposit is held in escrow until the closing.
Sometimes the buyer’s loan will determine the earnest money. For example, if it is customary to collect a 5% deposit, but the buyer is using an FHA loan, a 3.5% deposit may be acceptable.
Some buyers may put up a higher earnest money deposit to entice a seller when it is a hot seller’s market.
The earnest money deposit is typically fully refundable if the purchase does not go through, but in some cases, the seller can keep the deposit.
For example, if the buyer breaches the contract terms.
When buying new construction, it is also possible the builder may require more earnest money. Many builders like to get a ten percent earnest money deposit.
Where is Earnest Money Held?
Earnest money is held by one of four parties. Either the listing real estate brokerage, a 3rd party escrow company, a title company, or the seller’s real estate attorney.
The seller’s agent will collect the earnest money from the buyer’s agent when receiving an offer. It is one of the seller’s agent’s responsibilities as part of their representation.
How Does a Down Payment Differ From Earnest Money?
As we’ve noted, the earnest money is a substantial sum that buyers use to prove to sellers they are serious about buying a home. These monies go into escrow.
On the other hand, a down payment is funds that a buyer provides the seller at closing. This often leads to misconceptions that money will be handed over to lenders; however, this is not true.
Let’s look at an example of a home purchased for $500,000. The buyer is putting down 10 percent or $50,000. The agreed-upon earnest money is 5 percent or $25,000.
So, 25,000 would be held in escrow, and the other 5% would be given to the seller at closing.
Are There Any Times When Earnest Money is Not Collected?
It is rare, but sometimes when a buyer uses a VA loan, there will be no earnest money. A VA loan is a no-down payment loan. Often buyers using this type of financing do not have a significant amount of money in reserve.
A low or no earnest money amount may be accepted.
How Can a Buyer Lose Their Earnest Money Deposit?
A buyer can lose their earnest money deposit if they don’t meet the contingency deadlines in the real estate contract. Contingencies must be fulfilled before the sale can go through, such as obtaining a loan or a home inspection.
If the buyer does not meet the deadlines for these contingencies, the seller can keep the earnest money as a penalty.
For example, in a home inspection contingency, there is a date by which buyers must respond. If problems are discovered, buyers must ask the seller to remedy them or move forward.
When a buyer does not respond by their outlined contingency date, the contingency is no longer in force. The same can be said about the mortgage contingency clause.
Another way a buyer can lose their earnest money deposit is through buyer’s remorse. If a buyer decides to back out of the sale after signing the offer for no reason other than changing their mind, they could lose their earnest money.
Depending on the contract, the seller may have the right to keep the earnest money as a penalty.
What Happens When There is an Earnest Money Dispute?
When there is an earnest money dispute between buyers and sellers, the real estate brokerage holding the deposit should not release the funds until the dispute is resolved.
The real estate agent must use caution when deciding whether to release the earnest money and should be aware of their liability should they release the funds.
In the case of an earnest money dispute, a real estate agent should work to mediate the situation. In many states, the real estate contract stipulates in the event of an earnest money dispute the parties will try to mediate a resolution. If an agreement can’t be reached, a court of jurisdiction will need to resolve the dispute if an agreement cannot be reached.
The court will determine who is entitled to the earnest money deposit. The court will ask the real estate company to hold the earnest money in an escrow account until the dispute is resolved.
Final Thoughts on Earnest Money
Earnest money is an integral part of most real estate transactions. With earnest funds, there would be nothing holding a buyer’s feet to the fire to continue the transaction.
Earnest money is used to ensure the transaction proceeds to the closing.