Earnest Money/Escrow Deposits Explained
What is earnest money? How much is earnest money? How does earnest money work? What’s the difference between earnest money and down payment funds? These are all common questions that home buyers ask real estate agents daily. By the time you’re done reading, you’ll have a solid understanding of the answers to these questions.
There are plenty of terms and concepts in real estate transactions that can prove confusing or complicated, especially when you have never encountered them before.
Earnest money proves to be more complicated than confusing for most people, since the term does a good job of describing what it is – money the buyer gives to show they are earnest, or sincere, in their intention to purchase a home.
Although the term is easy enough to understand, the practice can become somewhat complicated, particularly if the deal falls through.
Both buyers and sellers need to understand the ins and outs of earnest money. Two other terms that may be used in place of earnest money are an escrow deposit or good faith monies.
Earnest money or escrow deposits are a crucial element of any home sale. Buyers should never confuse the difference between earnest money and a down payment.
Understanding Earnest Money
Earnest Money – What is It?
When a buyer makes an offer on a home, the buyer and seller will enter into an agreement that pulls the property off of the market so that the next stages of the sales process can happen – like the home inspection and home appraisal. But the agreement is not one that requires the buyer to purchase the home, at least not yet.
That wouldn’t work, since guaranteeing you will buy a property before it is inspected or appraised is a recipe for disaster. The seller needs some motivation to take the home off the market, though, because they lose out on any other offers that might come through. After all, even if the inspection and appraisal go well, the buyer’s mortgage commitment could fall through.
With earnest money, the buyer is showing the seller that they are serious about buying the home. The earnest payments are protection for the seller so that a buyer cannot just walk from a sale on a whim. The last thing a seller wants is to feel uneasy that a buyer could be out shopping for something better to come along.
By having earnest money, the seller would be compensated in the event the buyer decided not to purchase without a legitimate reason outlined in the real estate contract. Another way to think of these escrow funds is insurance in the event a buyer defaults.
Just how serious the proof shown by the earnest money needs to be, depends on the market. Earnest money amounts tend to go up in markets where homes are selling like hotcakes.
It is also essential to note that in many locations, the seller is limited to collecting the earnest money as liquidated damages. In other words, they can’t sue the buyer for more money for their lack of performance.
The language in purchase and sale agreements will often look something like this:
If the buyer doesn’t fulfill the buyer’s agreements herein, all deposits made here-under by the buyer shall be retained by the seller as liquidated damages. This shall be the seller’s sole remedy at law and in equity.
How does the earnest money process work?
Usually, the earnest money is handed over when the buyer and seller sign the purchase agreement or sales contract. However, there are certain situations where the money might actually be handed over when the offer is made. It all depends on the market conditions and the customs in the particular area you are buying.
When a buyer wants to purchase a home, they make an offer in the form of a home purchase contract. The contract is designed in a way that, as conditions are met, the buyer increases their commitment to the sale. The commitment begins with the earnest money deposit. These funds are known as “consideration,” which is an integral part of a real estate contract.
In the beginning, the earnest money is fairly easy to get back for the buyer. But as the sale process moves along, the money becomes more difficult to get back – eventually, it gets to a point where if the sale doesn’t go through, the seller gets to keep the earnest money.
The time in which a seller would be able to keep the earnest money is when all of the buyer’s contingencies have lapsed. Typically, one of the last contingencies to clear on the buyer’s part would be getting their mortgage. If a buyer has a firm mortgage commitment and there are no other contingencies left, a buyer would lose their funds if they did not proceed with the sale.
Real Estate agents are more confident to mark homes under agreement vs. contingent when there are no more hurdles left to clear.
Where is earnest money held?
In most real estate transactions, either the listing agent or the seller’s attorney will hold the escrow funds or earnest monies. Sometimes they are held in interest-bearing accounts, other times they are not. It really will depend on local customs.
When the earnest money funds are deposited, they go into an escrow account until the sale closes. When the sale closes, the earnest money is applied to the buyer’s purchase price for the property.
Sometimes earnest money payments are broken up into two different phases. This happens because, in some states, there are actually two contracts – one is the offer to purchase, and the other is the purchase and sale. For example, in Massachusetts, where I’m located, we are a two contract state.
If the payment is broken in two, the first payment will usually be somewhere between $500 and $5,000. The second payment will be the remainder of what the agreed-upon earnest money offer was.
What’s the Difference Between Earnest Money and a Down Payment?
Quite often, buyers are confused about the difference between the earnest money they put in escrow and the money they put toward their down payment. These are two distinctly different things. The funds are coming out of the buyer’s pocket, but they serve different purposes.
As previously mentioned, the earnest money is considered a good-faith deposit to make the seller feel comfortable; the buyer is serious about purchasing the home. A down payment should not be confused with earnest money.
What is a down payment?
On the other hand, a down payment is funds that a buyer pays directly to a seller at the closing. When people think of down payments, there is a common misconception that the money is going to the lender. This is false. The lender will want to know you have a down payment, but they don’t get these funds.
The balance of the home’s purchase price comes from the amount you mortgage. The money a buyer puts down on the house can come from several places, including personal savings, the sale of a prior home, or gift monies from a family member.
Down payments are almost always required to be made in the form of a certified cashier’s check that is brought to the closing. It’s also possible a buyer could choose to have funds wired directly from their bank.
The amount of down payment you choose depends on the mortgage program you’re going to use. There are numerous mortgage programs for first-time buyers. Some of the most popular include:
- Conventional loans – the lowest down payment amount on a conventional loan is 3 percent. It used to be 5 percent.
- FHA loans – the lowest down payment amount for FHA mortgages is 3.5 percent.
- VA loans – if you are in the military of are a veteran, you can put no money down. There are other requirements as well to read up on, but there are certainly benefits to a VA mortgage.
- USDA loans – USDA mortgages are considered rural loans. If you live in a rural area, you can also use USDA financing and put zero down.
For many years having a twenty percent down payment was the holy grail of mortgage lending. That is no longer the case, and it hasn’t been in quite a while. In fact, it is a significant mortgage myth.
Right or wrong, however, many sellers and their agents will look more favorable towards buyers who have larger down payments.
There is also a significant advantage to buyers who put at least twenty percent down – they avoid paying what’s known as private mortgage insurance, which can be expensive. It is a useless fee that protects lenders in the event of mortgage default. Most buyers will want to stop paying private mortgage insurance as soon as they are able.
What causes the earnest money to be returned to the buyer?
The home purchase contract specifies situations where the earnest money will be returned to the buyer. It is possible to set a wide variety of conditions that would trigger a return of the money, but most of the time, only a few are specified. These include:
- The home does not appraise for the sales price. The home appraisal is a significant hurdle for sellers to get their homes sold – both because buyers are not keen to pay more for a house than it is worth, and because lenders almost could deny funding if the appraisal does not meet the sales price. Lenders are not interested in purchasing homes for more than they are valued at because they will have trouble getting their money back through a sale if the borrower defaults on the loan. From time to time, there are errors on an appraiser’s part that could warrant fighting a low appraisal.
- The home inspection uncovers a significant defect. The home inspection is the other big hurdle for sellers to overcome. Most home inspections will find flaws, but usually, those defects are small enough that they can be repaired or accepted by the buyer eager to get the home. However, if the home inspection problem is significant enough – like a ruined foundation – the cost of repairs will be prohibitive. There may be no way to sell the home at the current price after a substantial flaw is discovered. Discovering unforeseen issues can be common when buying a fixer-upper home.
- The buyer is not able to procure financing. In most real estate contracts, there will be language that’s known as a mortgage contingency clause. The mortgage contingency clause shows the amount of money the buyer is looking to mortgage, a date by which they must apply for the loan, and when they will have the commitment from the lender. If the buyer is rejected for financing, they will be able to get their earnest money back as long as they notify the seller in writing before the expiration of their mortgage contingency. When a buyer does not inform the seller in writing before the expiry of said clause, the buyer can lose their earnest money funds.
What causes the buyer to lose their earnest money?
The most apparent reason why a buyer would lose the earnest money is if they back out of the contract for contingencies not listed in the contract. If the buyer decides not to buy the home for any reason that is not listed in the contract – even very legitimate reasons, like there is a significant defect in the house – then they will probably lose their earnest money.
Other common reasons for losing earnest money include:
- The buyer fails to meet the timeline in the contract. The contract will have a deadline that must be adhered to by the buyer. If the buyer fails to comply with the timetable – such as if they are unable to get their loan funded by the due date – then if they break the contract and don’t buy the home, they will lose the earnest money.
- The buyer has a change of heart and does not buy the home. There are times when buyers decide that they do not want to buy a home after entering a purchase agreement. If this happens and the buyer cannot link the decision to pass on the purchase to a contingency listed in the contract – like if the buyer just decides they don’t like the home anymore – then walking away from the purchase will result in the forfeit of the earnest money to the seller. Here are some of the most common reasons home sales fall apart.
How much earnest money does the buyer pay?
There is no hard and fast rule for how much earnest money a buyer needs to pay a seller, but there are typical ranges that are seen in most home sales.
Usually, earnest money payments will range between 1% and 5% of the purchase price of the home. However, if the housing market is really hot, the earnest money offers may shoot up to between 5% and 10% of the home’s purchase price!
Buyers may use a higher earnest money offer to sway a seller to sell them a home they really want in a high demand area. It is one of the tactics buyers will use to win a bidding war, along with possibly an escalation clause.
Buyers should talk to their real estate agents about what earnest money expectations are in their market once they start house hunting because there is a big difference between 1 and 10 percent. One percent of a $300,000 home would be $3,000, while 10% would be $30,000.
It is worth remembering that most sellers do not consider earnest money deposits as important as things like how fast you can close and how much down payment you are going to make on the purchase.
Buyers should always consult with their Realtors to determine what the best mix of terms would be to purchase a home they are interested in.
It should be noted as well that earnest money deposits when buying a new home are usually ten percent of the purchase price. Sometimes a builder will use these funds, and they will not be held in escrow like a traditional re-sale home. You should always consult an attorney before allowing a builder to keep your funds.
During the real estate bust, many builders went out of business, and buyers lost their deposit funds — an excruciating lesson, to say the least.
Earnest money mistakes
When you are buying a home for the first time, it is effortless to make mistakes when you don’t have proper guidance. This can easily happen when you don’t have a skilled buyer’s agent in your corner. Here are some of the most common earnest money mistakes you’ll want to avoid:
- Not putting enough earnest money down with your offer – In a hot seller’s real estate market, it is vital that you put at least the standard amount of escrow in your offer. You’ll be putting yourself at a disadvantage if there are other offers on the table.
- Not putting any earnest money down at all because you’re getting a VA loan or USDA mortgage – Over the years, I have seen many buyers lose out on homes because they are not willing to put any skin in the game. Just because you are getting a no down payment loan doesn’t mean you should have zero earnest money deposit. Put yourself in the seller’s shoes.
- Removing contingencies you shouldn’t – one the other side of the coin some buyers in an effort to make their offer stronger will waive standard contingencies such as a home inspection or financing to make their offer stronger. Be certain you don’t make the kind of blunder you’ll regret.
- Letting contingencies dates pass without responding – in real estate contracts, some timelines need to be met. As a buyer, if you don’t meet them, you lose that contingency. Make sure you pay careful attention to all deadlines.
- Fighting for money, you’re not entitled to – at times, buyers make costly mistakes and compound them by spending more time and energy trying to contest something there is no chance of winning. If you back out of a sale a week before closing for no other reason besides you changed your mind, let the deposit go.
Earnest money disputes
The last part of my earnest money guide discusses what happens in the event there is the release of an escrow deposit that is contested. In a real estate transaction that falls apart, it is not uncommon at all to have a dispute between the buyer and seller on who gets the earnest money deposits.
Many standard real estate contracts have language like the following:
All purchase deposits made shall be held in escrow by an escrow agent subject to the terms of this agreement and shall be duly accounted for at the time for the performance of this agreement. In the event of any disagreement between the parties, the escrow agent shall retain all deposits made under this agreement pending instructions mutually given in writing by the seller and the buyer.
If the dispute between the buyer and seller cannot be resolved, the escrow agent shall continue to hold said funds until a court of competent jurisdiction decides their distribution.
What this means is the real estate company cannot arbitrarily release the escrow funds even if they clearly believe one party is entitled to them.
Over the years, I’ve seen a few deposit disputes where things can get really nasty because of one of the parties believes the real estate company should release the funds – sorry they can’t.
Hopefully, you now have an understanding of how down payments and earnest money differ. You should also have an excellent idea of how earnest money works in a real estate transaction. If you are unclear about anything related to escrow funds, reach out, and I will try to help.
Other Valuable Real Estate Resources
- What not to do before closing – when you are buying a home, there are some things you’ll want to avoid doing financially that could cost you a sale. See, some of them spelled out in detail.
- What improvements offer the best ROI – if you are sure you’re going to be selling your home in the next few years, it makes sense to invest in your property wisely. Not every improvement is a good investment, and some can even make your house harder to sell.
- How to save money for a home – one of the most vital things to do before purchasing your first home is to become fiscally responsible. Part of doing so is becoming more of a saver than a spender. See some helpful tips on how to sock away money for a home purchase.
- Selling as a FSBO – do you know the pros and cons of selling a property for sale by owner? Find out what you need to know about selling without a real estate agent in this helpful resource.
- Consideration when selling a luxury property – trying to sell a high-end home is a bit different than your traditional sale. See some excellent guidance on getting a luxury house sold.
Use these fantastic articles filled with great advice to make the best decisions possible when buying or selling a home.
About the author: The above Real Estate information on what is earnest money in real estate was provided by Bill Gassett, a Nationally recognized leader in his field. Bill can be reached via email at [email protected] or by phone at 508-625-0191. Bill has helped people move in and out of many Metrowest towns for the last 33+ years.
Are you thinking of selling your home? I have a passion for Real Estate and love to share my marketing expertise!
I service Real Estate sales in the following Metrowest MA towns: Ashland, Bellingham, Douglas, Framingham, Franklin, Grafton, Holliston, Hopkinton, Hopedale, Medway, Mendon, Milford, Millbury, Millville, Natick, Northborough, Northbridge, Shrewsbury, Southborough, Sutton, Wayland, Westborough, Whitinsville, Worcester, Upton, and Uxbridge MA.