Buying your first home is not always easy. Homebuyers need to learn all sorts of new language related to real estate transactions. In particular, earnest money deposits confuse many first-time buyers. What is this payment? Is it mandatory? How much should I pay? As such, we’ll use this article to explain the earnest money deposit.
Specifically, we’ll discuss the following:
- What Is an Earnest Money Deposit?
- Contingencies and Getting Your Earnest Money Deposit Back
- Protecting Your Earnest Money Deposit
- How Much Earnest Money Should I Put Down?
- VA Loan Earnest Money Considerations
- Final Thoughts
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What Is an Earnest Money Deposit?
From a legal perspective, earnest money serves as consideration – or value – between a potential home buyer and the seller. Practically, earnest money deposits act as good faith from the buyer to the seller. In other words, these funds let the buyer tell the seller, yes, I am honestly considering buying your home, and this deposit proves it.
Earnest money also mitigates risk for sellers due to how long it can take to close on a home sale. The average home sale closes between 30 to 45 days after buyer and seller go under contract. For the seller, this is a long time to wait on trust alone. That is, during this period, the seller will have to turn away other offers – a difficult decision without some sort of guarantee. Earnest money deposits provide assurances that A) the current buyer is serious, and B) if the buyer walks away, the seller can keep the earnest money as compensation for the wasted time.
NOTE: As we’ll discuss below, several scenarios exist that allow the buyer to back out of a deal and keep his or her earnest money.
Normally, the buyer will pay the earnest money deposit immediately after going under contract. And, to avoid potential conflicts, buyers typically place these funds in an escrow account (as opposed to providing them directly to the seller). You can use your title company or a real estate attorney to hold these funds in escrow until closing. At that time, the funds will be applied as a credit to your closing costs and/or down payment. For instance, if you provide a $1,000 earnest money deposit, you’ll see a $1,000 credit on your settlement statement.
Alternatively, if you don’t close on a purchase, the situation becomes slightly more complicated, as we’ll discuss in the next section.
Contingencies and Getting Your Earnest Money Deposit Back
As stated, earnest money deposits provide sellers a good faith assurance that buyers are serious. Consequently, if a buyer backs out of a deal in breach of the sales contract, the seller keeps the earnest money as compensation. However, most sales contracts include several contingencies – or milestones – that allow buyers to walk away from a purchase and keep their earnest money. In other words, if you exit a deal in accordance with these contingency terms, all of your deposit is returned.
While not an all-inclusive list of potential contingencies, here are the most common ones included in residential real estate contracts. And, we’ve listed them in the normal sequencing of events, from contract signing to closing on the purchase.
Contingency 1: Home Inspection
The results of a home inspection often cause buyers to walk away from a deal. When professional home inspectors examine homes, they create detailed reports on the current condition of the home and its major appliances. As such, an inspection can uncover thousands of dollars (or more) in needed repairs (e.g. roof damage, code violations, damaged HVAC systems, etc.).
When major repair issues arise, buyers and sellers negotiate responsibility for completing those repairs. If a buyer is not satisfied with the results of these negotiations, a home inspection contingency allows him or her to back out of the deal and keep the earnest money deposit.
Contingency 2: Home Appraisal
When buyers finance a home purchase, the lender will require a home appraisal before approving the mortgage. Say, for example, that the contract price is $350,000. If the appraisal comes in at $300,000, the home appraisal lets the buyer walk away from the deal with his or her earnest money.
However, before leaving the deal, you should first use the results of the home appraisal to negotiate a lower purchase price. If the seller decides to lower the price to match the appraisal, outstanding. If not, you can still walk away from the deal.
Contingency 3: Mortgage Approval
Related to the home appraisal, many sales contracts include a mortgage approval contingency. This means that, if the buyer fails to qualify for financing, he or she can leave the deal and keep the earnest money.
For this reason, many sellers require a lender’s pre-approval letter before accepting an offer. This pre-approval provides assurance that, barring an unforeseen circumstance, the buyer will eventually qualify for the mortgage.
Contingency 4: Selling Your Current Home
Lastly, some homebuyers need to sell their current homes in order to buy a new home, generally to meet down payment requirements. Accordingly, a current home sale contingency protects buyers. If the sale of their current home falls apart, they can walk away from the purchase of the new home with earnest money in hand.
Waiving Contingencies
In particularly hot real estate markets, some buyers consider waiving some of the above contingencies to make their offers more attractive to sellers. While you can do this, we don’t recommend it. Contingencies exist to protect you as a buyer. Unless you’re completely comfortable losing your earnest money deposit, we advise including these contingencies in your contract.
Protecting Your Earnest Money Deposit
To protect your earnest money deposit, buyers can take a few proactive steps.
Step 1: Use an Escrow Account
As stated, you should never provide your earnest money directly to the seller. If you do, he or she could refuse to return your deposit – even if you leave in accordance with a contingency. While you could probably recover these funds via a lawsuit, that would entail unnecessary time and legal fees. Instead, just deposit your earnest money in escrow with an independent third party.
Step 2: Know Your Contingencies – and Their Timelines
Contingencies only protect you as a buyer if you understand their content and associated timelines. For instance, a home inspection contingency generally states that a professional inspection must be completed within a certain amount of time from going under contract (e.g. 10 days). If you complete the inspection after this timeline, it doesn’t matter what the report uncovers, you will lose your earnest money if you walk away from the purchase.
Step 3: Put It All in Writing
A home is a huge purchase – typically the largest most of us will make in our lifetimes. Therefore, you should include every single contingency, associated timeline, and changes to them in the contract (or addenda to the original contract). That way, you know with 100% certainty when you will – and won’t – get your earnest money returned to you.
How Much Earnest Money Should I Put Down?
It depends. No concrete number exists. Instead, buyers need to look at a variety of factors to determine how large or small of an earnest money deposit to offer.
Off-market vs. MLS Properties
Average earnest money deposits vary significantly based on how a buyer finds a home. Many investors pursue off-market properties. Inherently, these homes have less competition from other buyers. As a result, buyers can offer far lower earnest money deposits, often as little as $50 to $100.
Alternatively, people buying primary homes generally look for properties on the Multiple Listing Service, or MLS. Any real estate agent in the country can view these listings, which typically creates far more competition among potential buyers. Accordingly, buyers normally offer anywhere from $1,000 to $2,000 in earnest money deposits for properties on the MLS. In hot markets, some buyers can even end up offering tens of thousands of dollars in earnest money to have their offers accepted.
Buyer’s vs. Seller’s Markets
Additionally, the type of real estate market can significantly affect earnest money amounts. In a seller’s market, there’s more demand than supply of available housing. This gives sellers the upper hand in negotiations, meaning buyers generally must pay more in earnest money to have an offer accepted.
On the other hand, in buyer’s markets, supply exceeds demand. This situation leads to houses sitting on the market for extended periods, and buyers have the upper hand in negotiations with sellers. As such, a seller may accept a far lower earnest money deposit just to finally go under contract.
As a buyer, you may or may not have an in-depth knowledge of your local market. Fortunately, real estate agents tend to have an intimate understanding of local market conditions, to include reasonable earnest money deposits. As such, listen to your real estate agent. He or she will generally have the insight necessary to tailor your earnest money deposit amount to a particular offer.
VA Loan Earnest Money Considerations
Not Technically Required
Technically speaking, if you’re using a VA loan to purchase a home, you do not need to provide an earnest money deposit. That is, the VA does not require that buyers include earnest money in an offer. But, this reality doesn’t mean you shouldn’t provide earnest money. Unless you find yourself in an extreme buyer’s market, most sellers won’t consider a purchase offer that doesn’t include an earnest money deposit.
VA Appraisal and MPRs
When using the VA loan, a VA appraiser will confirm that the property meets certain habitability standards. In particular, the home needs to be safe, sound, and sanitary. To meet these standards, the VA imposes minimum property requirements, or MPRs, on properties. If a home fails to meet these MPRs, the VA appraiser will annotate issues on the appraisal report. When the VA administrators see these issues, they will put a hold on loan approval until the issues are resolved. If not, the loan will be disapproved.
Conceptually, these MPRs should fall under any home inspection contingency. But, to provide the seller full disclosure – and protect yourself – you should include a specific VA appraisal and MPR contingency in your contract. That way, if the property fails to meet MPRs, you know you’ll be able to walk away with your earnest money deposit.
Final Thoughts
For first-time homebuyers, earnest money deposits can cause significant angst and confusion. But, by following the above recommendations you can A) protect your earnest money deposit, while B) crafting a competitive offer that a seller will likely accept.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.
