What Is Earnest Money and How Does It Work?
If you’ve been researching real estate purchases or talking to a realtor about touring a home, you probably have heard the phrase “earnest money” pop up.
Earnest money is one of those terms that sounds pretty archaic and might throw off people who are new to the world of real estate.
Purchasing a house will always require earnest money, but it can be hard to understand what that means at first.
If you’re confused about this term, how it plays into the home buying process, and why it’s still a thing, keep reading we’ve got the answers for you.
What is Earnest Money?
- Earnest money is a deposit a homebuyer puts down at the time of contract in order to show good faith and their intention to buy a property.
- Earnest money is deposited into an escrow account until closing day and counted toward the home purchase price.
- The earnest money deposit can be the full amount of downpayment or just a percentage of it.
- If you are afraid your earnest deposit is not refundable if something happens to your deal, you should speak with your real estate attorney.
- Earnest money can also be requested when applying for a rental apartment. Always make sure you know what the refund policy is before you hand over any funds.
What Is Earnest Money, And Why Is It Used?
Most people know that buying a home is a long process that can fall through at almost every twist and turn.
In order to understand the reasoning behind earnest money, you have to understand what once used to happen.
In the past, there was a tendency for people to pretend to be willing to buy multiple houses before they decided on one.
To give themselves time to make a decision, they would put “holds” on multiple houses, but only buy one while letting the other sales fall through.
To prevent this, homeowners and realtors decided to ask for potential buyers to place a portion of the home’s price in an escrow account until closing.
This money is physical proof that you have a real intent to buy the home, and are honest about your intent.
Earnest is an old school way of saying “honest,” which is where the term earnest money is derived.
The importance of being earnest in your intentions is that it prevents the sellers from missing out on a person who would genuinely love the house if you’re not ready for it.
When is the earnest money required?
Worried about having to plunk down cash before you even tour a building?
Is earnest money the same thing as a downpayment?
It's already a given that most homebuyers will have to put down a downpayment. So, how is it any different from earnest money?
Earnest money actually has directly to do with the downpayment in that that the money is debited from the downpayment.
In some cases, the earnest money will just be a percentage of the downpayment depending on the conditions both sides agree to. In others, it will be the entire downpayment.
Generally, putting down the entire downpayment as your earnest money deposit will increase the faith of your sellers.
It not only shows your willingness to put your money where your mouth is but also shows your liquidity and ability to afford the house or mortgage.
How do you give earnest money?
Earnest money is done as a certified check, wire transfer, or personal check that’s deposited into an escrow account that will be accessed at closing.
If the earnest money is just a portion of your downpayment, the remaining amount of the downpayment will be paid in full at the closing table.
Your real estate attorney will walk you through the process if you’re feeling a little lost.
How Much Earnest Money Do You Have To Have In Order To Reserve A House?
This all depends on a number of factors, including the community that you’re moving into, local laws, as well as the agreement you made with the seller.
Generally speaking, you will need to put down 1 percent to 2 percent. Some communities may just require a flat fee.
Not sure how much money you should put to down? Here are some guidelines and advice to follow:
- Check the contract and realtor agreement. The amount of earnest money you should put down will be in the contract.
- If you haven’t put the offer out yet, ask the seller what they feel would be good. The seller will be able to give their own guidelines, and if they can’t, their realtor will be happy to do it for them.
- Check your co-op or condo’s policy. If you are purchasing a co-op or a condo through financing, the company in charge will have policies in place regarding the earnest money requirements.
- Though the standard earnest money deposit is 1 to 2 percent, hot housing markets like NYC might see fees as high as 5 to 10 percent. The earnest money deposits tend to be a reflection of the demand people have for that home.
Do I have to fill out any tax forms with earnest money?
If the amount of earnest money you have to put down exceeds $9,000, federal law will require you to fill out a W-9.
This is only done since the money you place in escrow can receive interest, and you might want to collect that while it’s waiting there.
However, this may not be worth it if the earnest money is less than $9,000, although you may be asked by the seller to do so.
Some brokerages will require you to fill out the W-9 form regardless to protect themselves in case of an audit.
You will be asked for your social security number in the case of a W-9 form. If you don't feel comfortable sharing your social security information speak with your attorney.
Is earnest money refundable?
Whether or not you get the money back depends on what happens with the sale and transaction.
If the sale goes through, the earnest money is used to help with the closing costs.
However, if you decide against buying the home for reasons that don’t have anything to do with the inspect, the seller keeps the fees.
If the sale falls through due to a bad inspection or appraisal, the money will be refunded to you.
Moreover, if the seller decides to renege on the sale, you also should expect to get the money back since it is not your fault the sale fell through.
The terms are not always black-and-white, so you need to discuss the what-if's with your attorney before you take any action.
It is still possible for a buyer to walk away with your earnest money even in the case of leaving the deal due to a more frivolous reason, so it's not an open-shut cake.
How To Keep Your Earnest Money Safe
The problem that many people have with purchasing real estate is the paperwork and the bureaucracy of it all.
Because things get so confusing, there have been occasions where people have lost their earnest money.
These tips below will keep it from happening to you:
- Make sure that the earnest money and escrow is handled by a reputable group. You shouldn’t trust your earnest money with just anyone. You should always let the escrow account and its deposits get handled by a trusted bank, escrow firm, lawyer, real estate brokerage, or title company. You should never directly hand the check to the seller!
- Keep a close eye on your contract. Your sales contract is there to protect both you and the seller. Read it and follow it down to the letter. Otherwise, you might have the deal fall through and lose your deposit in the mix.
- Always make sure that every contingency and note you’ve made about the house is in the contract. Without noting everything down, you won’t be able to back out of a deal if you decide it’s not a good option.
- If your seller reneges on part of the agreement, speak up and get your refund. Let’s look at an example of this in action. Jared is buying a house from Julie, and they both agree that Julie will fix the leaky ceiling in the kitchen by the time the move-in date arrives. The date comes in, and Julie still didn’t fix the ceiling. Jared cancels the transaction and gets his refund. Without him keeping an eye on the contingencies, he would have had to pay that repair money out of pocket or lose his earnest money.
How should you view earnest money?
A lot of homebuyers view putting down earnest money as a pain, but you shouldn’t see it this way.
Earnest money is a major step that shows just how close you are to closing your home, and it also acts as a way to protect yourself from the seller acting in bad faith.
By plunking down your earnest money, you start the countdown timer to your move-in date.
That’s a huge push in the right direction and is worthy of celebration any way you look at it.
Other Real Estate Uses of Earnest Money
The other transactions where earnest money may be utilized are with rentals.
The earnest money deposit may be as little as a couple of hundred dollars to the full security deposit amount.
Like in the case of a downpayment, the more you put down, the more it shows your intention of signing a lease.
Also like sales, it can be a place holder of sorts while not exactly guaranteeing that you get the apartment.
Earnest money is usually requested at the time of your application and credit check.
In some situations, you can use a credit card to put down the earnest money, while others may require refundable guaranteed funds, depending on the brokerage or company.
In any case, make sure you read up on their refund policy just in case the application doesn't work out.
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