What is Earnest Money and Why is it Needed?

When a buyer agrees to purchase a property from a seller, the buyer usually pays earnest money as a deposit on the home. The earnest money amount varies based on the type of deal being done and the price of the home. The earnest money goes along with the contract to buy and sell but is usually refundable based on certain contingencies. Those contingencies may involve a home inspection, an appraisal, the buyer’s loan, homeowners insurance, a survey, or many other items. In most cases, the earnest money tends to be about 1 percent of the purchase price of the home. The use of earnest money and contingencies is very common with real estate in the United States. earnest money may not be needed on every deal and every state has different ways they handle earnest money so be sure to check with real estate agents to understand what local laws and customs are in your area.

How much is the earnest money on most homes?

I have been a real estate agent and investor in Colorado for almost 20 years. The amount of earnest money varies based on the buyer, the seller, and the particular deal. The amount can also vary based on location and what state you are in. Typically the earnest money is about 1 percent of the price of the home. For houses that are $100,000 to $2000,000, the earnest money is usually $1,000. For homes that are $200,000 to $300,000 the earnest money might be $2,000 or $2,500 as you get closer to the $300,000 price point. The minimum earnest money amount is usually $1,000, although I have seen it as low as $500. For more expensive houses you will see a higher earnest money deposit asked for.

In some instances, the earnest money could be more. With some REO sellers (banks selling foreclosures), the earnest money could be as high as 10 percent of the price of the home. Fannie Mae requires 10 percent earnest money on offers made with cash. A home buyer could also increase the amount of earnest money if they want to make their offer appear better than other offers. Some sellers who are typically selling homes that need a lot of work may ask for higher earnest money as well to make sure the buyers are serious.

Is earnest money negotiable?

The seller will typically ask for the amount of earnest money when a home is listed on the MLS (multiple listing service) when they list a home with a real estate agent. This is information given to the buyer for what the seller is expecting in order for them to accept an offer. The buyer can offer more or less in their offer to buy but if they offer less there is the chance the seller will not accept that amount or go with an offer that has more earnest money if there are competing offers.

How is earnest money paid?

The earnest money is usually paid within a couple of days of the contract being signed by all parties. Most sellers will accept personal checks for earnest money, but some may require certified funds. HUD and some banks who are selling their foreclosures will require a cashier’s check or money order. The company holding the earnest money check will cash it as soon as they receive it. You cannot ask them to hold it for a few days or a week until you have enough money to cover it. If the seller does not receive the earnest money in a timely manner, they can cancel the contract. Some sellers will also require the earnest money check (or a picture of it) to be present with any offer before they will look at the offer. You can pay in cash but most agents and title companies will hate that and some may not accept it.

To learn much more about the house buying a selling process, check out my book: How to Buy a House: What Everyone Should Know Before They Buy or Sell a Home. It is on Amazon as a paperback or Kindle.

What if the buyer does not have enough money?

Some buyers can qualify for loans with very little money down. VA loans require no down payment and the buyer will sometimes get money back at closing after they buy the home because they get part of their earnest money back. Sometimes a buyer must sell their house before buying another house, and they have to use the proceeds from the sale of their home to pay for the new house and earnest money. It could be the buyer just needs to wait until they get paid again before they can afford earnest money. There are ways to get a seller to accept a contract on a home, without actually paying the earnest money right away.

Buyers can use what is called a promissory note for earnest money, which is basically a loan from the seller to the buyer. The buyer will agree to pay the earnest money at some point in the future. Even though you can write an offer with a promissory note for earnest money, that does not mean the seller has to accept it. When a buyer uses a promissory note for earnest money, the seller may have serious questions about the buyer’s ability to purchase the house. If the buyer cannot pay the earnest money, will they really be able to afford an entire house? I think it is best to avoid using promissory notes if at all possible.

Who holds the earnest money?

The buyer does not pay the earnest money directly to the seller. In Colorado, we use title companies for almost all transactions, as do many other states. In some areas, attorneys are used to handle the escrow process on real estate deals. Usually, the title company or attorney will hold the earnest money until the home closes or it is released to one of the parties. It is also possible for the real estate agent’s office to hold the money or other parties to hold it as well. T

Is the earnest money non-refundable?

Typically the earnest money in real estate deals is not non-refundable. The buyer has many opportunities to back out of the deal and still get their earnest money back. When a buyer (usually the buyer’s real estate agent) presents an offer to the seller, it contains contingencies. The contingencies are things the buyer or seller must find satisfactory by a certain date for the contract to continue. If the buyer or seller does find something unsatisfactory, they must notify the other party in writing of their objection by the date listed in the contract. For example:

  • The buyer has until July 15th to complete their home inspection.
  • The buyer finds out the roof is bad and they want it fixed.
  • The buyer must send the seller (usually seller’s agent) an inspection objection notice by July 15th or sooner notifying the seller that they must agree to repair the roof by the time the house closes, or the contract will terminate.
  • If the seller agrees, the contract continues, the seller has to get the roof fixed, and everyone is happy.
  • If the seller will not fix the roof, the contract will terminate and the buyer will get their earnest money back, as long as they notified the seller by the contingency date. If they waited until July 16th to tell the seller, the seller could keep the earnest money.

There will be other contingencies for many other items:

  • Title: This ensures the seller has a clear title and can sell the home legally.
  • Home insurance: In some cases, a home can be tough to insure if there have been too many claims in the past.
  • Appraisal: Most lenders will require an appraisal that values the home and notes if there are any repairs needed for the loan.
  • Survey or ILC: Some lenders will require a survey or improvement location certificate (ILC) to show exactly where the lot lines are and make sure there are no boundary problems.
  • Loan approval: The buyer must get their loan approved or give notice that they cannot get their loan.
  • Conditional sale: When a buyer must sell their home before they can buy a house themselves, they will sometimes have a contingency for when their home must sell or go under contract.

There can be many other contingencies having to do with HOAs, leases, disclosures, and much more.

What if the buyer cannot meet some of the deadlines?

If the buyer needs more time for loan approval, they do not have to terminate the contract. They can ask the seller for more time by sending them an extension. The seller does not have to agree to the extension, but it gives notice to the seller that they must sign the extension to give the buyer more time, or the contract will terminate, and the buyer will get their earnest money back. Usually, the seller will agree to extensions if they are reasonable and there is a valid reason behind why the buyer wants an extension.

If the buyer misses a deadline and does not notify the seller that they are terminating or want an extension, the earnest money technically defaults to the seller, but it can be trickier if both parties do not agree.

What if the buyer just wants to get out of the contract?

If the buyer decides they should not buy a house or they do not want to buy the house they have under contract, they can usually get out of it. In Colorado, if the buyer is still in the inspection period, they can terminate the contract without any reason or without giving the seller a chance to fix anything, and get their earnest money back. This has happens to me when I am selling houses and it can be frustrating, but there is nothing the seller can do.

If the buyer is past the inspection deadline they may still be able to get out of the contract and get their earnest money back. They could ask their lender to say they no longer can get the loan, or use another contingency to wiggle their way out. This is not exactly ethical, but it does happen.

How to get a great deal on a home.

What happens if the buyer and seller cannot agree on who gets the earnest money?

There are sometimes earnest money disputes where the buyer and seller cannot decide as to who gets the earnest money. There are some cases where a date was missed, but the buyer thinks the seller was not acting in good faith. The seller may not have fixed something as well as the buyer thinks they should have fixed it for an inspection issue. Sometimes a real estate agent may not have sent in a notice on time to another agent. If there is an earnest money dispute, the party holding the earnest money will not release to either party until a solution is reached. The seller will not be able to sell their house to another party if there is an active earnest money dispute, which puts the seller at a disadvantage.

In most contracts, the buyer and seller agree to go to arbitration or mediation if there is an earnest money dispute. If the buyer and seller cannot come to an agreement in regards to the earnest money, they will have to pay a third party to figure out who will get it. The cost to have a third party make decisions are usually as much as the earnest money. It is very rare that the parties will not come to some type of agreement on who gets the earnest money or if it is split.

How can you use earnest money to get a better deal on a house?

When I buy houses as a real estate investor I will waive my inspection and all contingencies except for clear title. This lets the seller know I am serious about buying their house and often gets my offer accepted over higher offers that have more contingencies. When I remove my contingencies the seller knows that if I back out of the contract, they will get my earnest money. With other buyers who have contingencies, they may have the home under contract for weeks, and the buyer could back out and get their earnest money back.

Another strategy is to raise the earnest money and remove your contingencies. This really lets the seller know you are serious and will buy the house if your offer is accepted.

Conclusion

Earnest money is a requirement when buying almost any property. You can try to get away without paying it, but it will make your offer much less desirable to the seller. In today’s hot real estate market I am trying to make my offers more desirable, not nickel and dime the seller. In most cases, if you are working with a good real estate agent and good lender, you should get your earnest money refunded if there is a problem.

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