How Does Earnest Money Work?

Certified Mortgage Advisor
NMLS 1701021
Published 
September 18, 2020

Make your earnest money work for you

We're talking about how does earnest money work. You're going to understand how you can keep your earnest money if a deal falls apart and why it might be helpful to have earnest money to be able to have your offer stand out amongst all of the other offers.

Earnest money is also good faith deposit

So first of all, earnest money, people also call this a good faith deposit and it means exactly that. It means, hey, this is money that we're going to put on the contract when you put in an offer on a home to be able to say, hey, we're putting some skin in the game. We're serious about buying this home because the seller wants to know that you're serious when you put in an offer if they're going to accept it.

Paid up-front with accepted offer

So earnest money is paid upfront with the accepted offer. So what that means is let's say you see house it's 123 Main Street. You say, hey, we want to write an offer. So you write an offer for maybe $200,000 and you say, hey, we want to put $2,000 in earnest money on that contract. So the seller now sees that.

You don't have to give up the $2,000 until they accept that offer. So it's money that you're putting on the contract is to tell the seller, Hey, when you accept this offer, we're going to go ahead and put some money in that's going to be held by a third party. So they're going to hold it so there's no dispute over somebody taking the money. But just to show you that we're going to put money up front and you don't have to wait all the way until the end to see if we're actually going to follow through with our promise on this contract.

Gives seller compensation

So the main point of this is it gives the seller some compensation if the buyer backs out, because put yourself in the shoes of a seller, imagine you accepted an offer for somebody to buy your home and you go through a whole process and maybe you're 25 days in and then all of a sudden, the buyer says, you know what? We just don't feel it anymore and they walk away. Well, you, as a seller, you made plans around somebody purchasing your home. So earnest money can be some compensation for the seller when things don't work out in the seller's favor.

Now there are protections for the buyer. There are a lot of circumstances when the buyer can get that money back, and circumstances where the buyer can lose the earnest money. We'll talk about those here at the end.

How much money do we need?

So when we're talking about how much earnest money does you need, it's really going to be best to talk with a Realtor about how much earnest money you want to put on a contract.

Areas that needs earnest money deposit

For instance, it's very common in my local market for people to not use earnest money at all. Earnest money in some markets is becoming a little bit of an outdated practice and it really just depends on how competitive the market is and what's going on in that market. For instance, you know, I'm in Dayton, Ohio, so or average median income is lower than most areas, most bigger metropolitan areas. So most people don't put a lot of money down, upfront, but you go to a higher-income area, let's say somewhere like Brentwood, Tennessee, or Nashville, then you're going to see earnest money be higher because people have more income and assets to put down on contracts and the market's really, really crazy.

Why? To stand out!

So now let's talk about why would we want to do this. Number one, i's going to help your offer stand out. If you have, if a seller sees two identical offers, they're both the same purchase price all the details are the same, but one buyer says I'm not going to put any earnest money down and the other says, we're going to put $3,000 down. Then the seller is going to say, well, this buyer is more serious. They're willing to put more money up front.

Contracts are a big deal

This is why earnest money exists in the first place. Sometimes what people will do is they'll go write on a home, they'll write an offer for a home, but they're not actually willing to follow through with that contract.

Treat it a like a real contract

That becomes a really big issue because you're tying a lot of people up in the process when you're trying to get home. So you need to treat it like a contract that you need to execute. You have to follow the rules inside of that contract. If you get out of it, then you run the risk of losing your earnest money.

Do you need it?

This is going to depend a lot on the market that you're in. If you can, it's always best to not put earnest money down or put as little possible down. So you're risking as little as possible and just creating less complexity in your purchase. But some markets might require it.

Ask your realtor

So again, talk with your Realtor about, hey, is earnest money needed? If so, how much do you think that we actually need to be able to get this offer through?

Credit toward closing cost

Now, at the very end your earnest money is credited towards your closing costs. So it's not an extra fee. Sometimes people feel like it's an extra fee. Think of it almost like a pre down payment. So, let's say that you put $2,000 earnest money on an offer. Well, within maybe the first week of being under contract, you'll go and submit that $2,000 to a third party. Maybe it's the seller's Realtor or it's your buyer's realtor.

It really just depends on who's holding it

Maybe a title company is holding it. So you submit that $2,000. Now let's say at the very end of the contract we're maybe 25 to 30 days later, and your final cash due at closing is $10,000. What will happen is the $2,000 that you already submitted is going to be deducted from the final amount. So you actually owe $8,000 because you already prepaid $2,000. And the reason why you prepay that amount is it gets held in this contingency fund in the event that there has to be a dispute over who gets earnest money.

#CalmMoment

So we're gonna talk about how to make sure you don't lose the earnest money in that account, but first, let's have a #CalmMoment. So if you're considering earnest money, you're probably in a competitive market, and it can feel like things are moving so fast. When everything's speeding by us, it's easy to make decisions that we maybe didn't think through very quickly.

This happens, I see this happen so often with buyers where they go and write an offer on a home because they kind of were feeling it emotionally, but, then they didn't go follow through with that contract. They got cold feet and had to walk away and ran the risk of losing their earnest money.

Things to consider

So really what I would say is take a moment to really consider: is this something that you want to do? Sometimes it's really helpful to just begin writing down: why do you want to purchase a home?

Are these numbers going to make sense for you? Did the logistics make sense? Don't go through this process and just get caught up and be led by the emotion, through the process because the emotion will carry you way too far in a direction and a distance that you don't want to be in.

How do we make sure we don't lose our earnest money

First, we need to talk about and understand contingencies. So contingencies are elements of your contract that basically give you a period of time, a little window where you can exit the contract completely legally with no problems.

Appraisal contingency

So a couple of those are you have an appraisal contingency. So this is where it says, hey, the home has to appraise for the purchase price or the buyer can back out.

Inspection contingency

You also have an inspection contingency and the inspection contingency normally says something like the buyer has 10 to 15 days to inspect the property as long as it meets the buyer's standards, then they can move forward with the contract. If the buyer, for any reason, doesn't like what they see in the inspection. They can exit the contract legally.

Financing contingency

Then you also have another one which is financing. So if you're getting a loan for a home, this financing contingency, says the buyer has a certain amount of days to get approved for a loan and if they don't, they can exit the contract legally.

Don't loose your earnest money, take note of the window

So these contingencies give you outs in the contract if you need them. This is important when it comes to earnest money because if you get out of a contract pre contingency, meaning you're still within those windows where you're allowed to exit, you can get your earnest money back.

Don't loose your earnest money

If you exit a contract post contingency, then your earnest money is in jeopardy. So again, the earnest money is held by another party and it's refundable if you're in the pre contingency period.

Let's run an example

Let's say you put $2,000 in earnest money. Let's say the title company is holding it right now. Then let's say the property appraises for $10,000 lower than the purchase price. Well, you can back out of the contract and get your earnest money back.

Refundable as long as your in the contingency window

It's refundable to you because you're in your contingency period, or let's say you have an inspection and you got that done and came back and there was a bunch of mold and maybe some structural issues. You can back out and get your earnest money back.

Outside the contingency window

Now, some things you have to watch for is if you get outside of your contingency windows. So for instance, like an inspection might say, the buyer has to do this within 15 days. Well, if you do your inspection on day 16, and then you want to back out, you're outside of your contingency window for the inspection.

If you back out because of the inspection results you fall under this post contingency category and the seller might be able to keep your earnest money. So if you try to back out of the contract, post contingency, meaning, you're following everything in the contract. There's no more out anymore.

Your appraisal came in fine, you have financing, your inspection came back fine. If you back out, just because you got cold feet or you don't feel it anymore, or some other deal came up, the seller has the potential to keep that earnest money. Now, it's not an automatic thing. Earnest money can kind of have some drama going on to it because it has to be agreed upon or arbitrated on how it gets handled.

It's bound by an agreement

So first it has to get agreed upon. So no matter what happens, pre contingency or post contingency, both parties have to sign on the earnest money saying, hey, you know, as a seller, I agree to give it back to the buyer. Or maybe the seller says, hey, I don't agree to give it back, and it might have to be arbitrated. Now different contracts, spell out how earnest money is handled in different ways.

For instance, in our local market, if a seller wants to keep the earnest money, it actually has to go into a trust fund for two years, and then it's given back to the buyer unless they pursue legal action. In other markets, it's not like that. Read your contract and it's going to spell out how earnest money is handled.

It's seller's protection

But what this is really doing for the seller is it's giving them compensation if a buyer backs out. It's preventing buyers from just going around and making offers that they're not really serious about following through.

Remember this

So the biggest thing to remember is to make sure you're meeting these contingency dates. Ask your realtor what those are, make those notes on your calendar. So, you know when your inspection date and an appraisal are coming up. Check if everything's moving along fine. That way you don't run into any of these issues with earnest money.

Know what your getting into and take note of the details

Earnest money really doesn't give too much of a hassle, but sometimes it can add a little bit of drama if things go a little bit south. So it's always good to know what's going on with the earnest money. How much do you need to put down and then those dates to keep in mind as well.

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