What is an Earnest Money Deposit in Real Estate?
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If you're selling a home, you no doubt want to get it off the market in a timely manner. But, settling for the wrong buyer can cost you more time in the long run if they end up backing out of the deal. This is where earnest money comes in handy.
An earnest money deposit, commonly referred to as an EMD in real estate, is a one-time fee the buyer pays to show they are committed to purchasing a home. Most sellers require this deposit as a form of risk mitigation and to ensure that the buyer sticks with the sale through closing.
Read on to learn more about an earnest money deposit and what it means for both the seller and buyer.
Why is earnest money important for the seller to receive?
The last thing you want as a seller is for a buyer to back out at the last minute after you’ve already taken down your “For Sale” sign. A buyer who has put down an earnest money deposit is less likely to change their mind about purchasing your home, so you can confidently take it off the market (putting the listing into a Pending Sale status) while it gets appraised and inspected and face less risk of the sale falling through.
Is earnest money a down payment?
While an earnest money deposit is made before a down payment, the former may become a part of the latter. Once a buyer has committed to purchasing your house, they can use the money they've already paid with their EMD to cover the down payment or other closing costs on closing day.
How much earnest money should a buyer put down?
In Texas, the average amount for an earnest money deposit is about 1% of a home’s purchase price. However, the more competition there is to buy a house, the more money a buyer may be willing to put down. While it's rare to exceed more than 1-3% in Texas, it's not unheard of for a buyer to pay 10% of a home's value in earnest money – in an especially hot market.
Be aware that if a buyer isn't willing to spend a significant amount of money (or any money) on an EMD, the seller faces a higher risk of not successfully closing. This is doubly true when selling to a cash house buyer.
Some cash buyers are wholesalers looking to make a quick buck by reselling their spot in the homes they get under contract. A buyer like this may offer an earnest money deposit as low as $100 so they can safely back out of the sale without much money lost if they can't find a buyer of their own to assume their place in the sales contract.
When do you pay earnest money in real estate?
In most cases, earnest money must be submitted within three business days of an executed sales contract. Texas law specifically requires that all earnest money deposits meet this deadline.
Who does the earnest money deposit go to?
As a seller, you may expect to keep an earnest money deposit for yourself, but this is not the case. The purpose of earnest money isn’t to increase your profit; it’s to ensure that a buyer is serious about closing. As such, the buyer will provide an earnest money check made out to a third party, such as a title company, legal firm, or real estate broker. The money will then stay in the third party’s escrow account until closing.
What happens to earnest money at closing?
Two of the most commonly asked questions about where earnest money ultimately ends up are:
- Is earnest money applied to the down payment at closing?
- Does earnest money go towards your closing costs?
In most cases, the earnest money goes towards one or both of the above. However, in some situations, such as when a buyer takes out a government-backed home loan that does not require a down payment, money may be left over after closing costs. In this scenario, the buyer would have the extra money returned to them upon closing.
What happens if a buyer doesn’t pay earnest money?
Whether or not you require a buyer to pay earnest money is up to you as the seller. However, if you do choose to include an earnest money deposit as a mandatory component of your sales contract, the buyer needs to adhere to that rule.
If a buyer doesn't pay the required EMD by the specified deadline, the contract becomes null and void, and you have the right to cancel the sale entirely.
Can earnest money be refunded to the buyer?
A home sale contract should come with various contingencies to protect both the buyer and the seller. If any of these contingencies are not met, it can trigger the cancellation of the sale and cause the buyer’s earnest money deposit to be refunded.
Here are some common scenarios of when a home sale may not meet the terms of its contract:
- The home inspection reveals issues that make the purchase undesirable for the buyer.
- The appraisal determines that the home is worth less than the selling price, and the seller refuses to lower the price.
- The buyer is unable to qualify for a mortgage.
- The buyer cannot sell their current home and therefore lacks the funds to buy a new one.
It is also a common practice for a sale contract to include an option period (also known as a due diligence period outside of Texas), during which the buyer can back out of the sale for any reason without repercussions. If a buyer decides against buying a home during this timeframe, their earnest money must be returned.
What is a non-refundable earnest money deposit?
Some contracts may specify that an earnest money deposit is non-refundable. This means exactly what it sounds like: the buyer will not get their money back under any circumstances.
While some buyers may offer a non-refundable EMD to stand out amongst the competition, this is an extremely risky move and not recommended for most non-professional home buyers.
What is a release of earnest money form?
For a buyer to get their earnest money refunded, both the buyer and seller must sign a release of earnest money form. This document confirms that both parties agree on the return of the earnest money back to the buyer.
What happens if a seller refuses to release earnest money?
Sometimes a seller may refuse to sign a release of earnest money form, even if the buyer is unambiguously entitled to a refund. If the buyer cannot convince the seller to release their earnest money, they may need to hire a real estate attorney.
Of course, a buyer in this situation must determine if it is worthwhile to pursue legal action. If legal fees cost more than the amount of the earnest money deposit, it may be best to cut one's losses.
How long does it take to get refunded earnest money back?
Getting an earnest money deposit refunded usually doesn’t take long at all. In most states, the party holding the earnest money must return it to the buyer within 48 hours of them officially backing out of the sale.
In what scenarios can a buyer lose their earnest money?
A buyer can only get their earnest money back according to the terms outlined in the sale contract. Failure to adhere to those terms, such as missing deadlines, can cause buyers to forfeit their right to an earnest money refund.
Some buyers also give up this right by waiving the contingencies of their contracts. Waiving contingencies may give a buyer an edge up on the competition, but this initial advantage comes with a huge risk—it means there is nothing to protect them if the sale falls through.
Can a buyer get their earnest money back if their financing falls through?
Whether or not financial issues are grounds for the release of earnest money depends on the contract’s terms. If it specifies financing as a contingency, the buyer can get their earnest money refunded, provided they cancel the sale within the timeline laid out in the contract. Otherwise, the earnest money does not need to be returned.
What is the difference between due diligence vs. earnest money?
Some sellers may ask that a buyer pay a due diligence (or an option) fee in addition to the earnest money. Like an earnest money deposit, a due diligence fee shows that the buyer is seriously interested in the property and is paying for the opportunity to perform their due diligence on the property via home inspections, etc. and gives the seller an extra form of insurance that the sale will proceed.
A due diligence fee differs from an earnest money deposit as it is non-refundable and goes directly to the seller.
What is the difference between an option fee vs. earnest money?
Most sellers will require a buyer to pay an option fee, regardless of whether or not they ask for earnest money. Like a due diligence fee and unlike an earnest money deposit, this fee is non-refundable and pocketed by the seller.
Note that an option fee differs significantly from both of the above payments in terms of cost. While due diligence and earnest money amounts are a set percentage of a home's selling price, an option fee is a smaller flat amount, usually no more than $500.
What is the difference between escrow vs. earnest money?
There are two different kinds of escrow accounts. The first is used to hold earnest money until a buyer closes on a home, while the second is provided by a mortgage lender after a buyer moves into their new home.
An escrow account of the latter type collects a portion of a homeowner's monthly mortgage payments, including property taxes and insurance.
What if a buyer doesn't have earnest money to put down?
A buyer purchasing a home through a government program like a VA or USDA loan may not expect to pay a lot upfront, as these loan types do not require a down payment. But even without a down payment, the buyer will still have to pay various costs, such as inspection and appraisal fees, as well as earnest money. Buyers who receive proper guidance from their real estate agent and lender will be well aware of these fees and be fully prepared.
As a seller, it’s always best to require an earnest money deposit and don’t take no for an answer. A buyer who doesn’t put down earnest money will have a much easier time walking away from the sale and leaving you back at square one. Insisting upon the payment of earnest money is a sound way to protect yourself from this risk.
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At AMI, we always put down a minimum of 1% of the purchase price or $1,000 (whichever is greater) as an earnest money deposit so you know we are serious about purchasing your home. Contact us today to get a no-obligation offer for your home.