You’ve finally found your dream home and you’re getting ready to make an offer. It’s an exciting time!
But there’s also a lot at stake. The financial decisions you make while buying your home can affect your long-term net worth. After all, your home is likely to be one of your most valuable assets.
Before you submit your bid, it’s important to understand what an Earnest Money Deposit (EMD) is, how you can use one to strengthen your offer, and how to protect your money should anything come up during your home-buying process.
Here’s what you need to know:
What’s earnest money?
Earnest money (sometimes called a “good faith deposit”) is money that accompanies your offer and tells the seller that you’re serious (“earnest”) about your bid.
If you back out of the deal for any reason that’s not covered in your contract (for example: cold feet), you could lose your earnest money deposit.
EMDs are not legally required, but sellers can contractually require them. Essentially, an EMD is an incentive for the seller to accept your bid and remove their home from the market.
Determining your earnest money deposit
Your EMD can make or break your offer, especially when there are multiple bids involved. A seller is more likely to accept an offer with a higher EMD, because by putting more money on the line, the borrower is showing that they’re serious about closing on the home.
How much you can expect to pay
In some markets, an earnest money deposit can be as little as $500 to $1000. In most states, EMDs are typically 1% to 3% of the total purchase price. In higher-priced or competitive markets, deposits can reach up to 10%.
- California does require some “consideration” or funds offered to secure a purchase contract.
- In Colorado, MLS listings show the seller’s required minimum earnest money deposit. Similar listings can also be found in other markets.
You can negotiate: Even if sellers list EMD minimums, these numbers are often still negotiable, particularly in buyer-friendly markets. Ask your real estate professional about effectively negotiating earnest money in your market.
New builds: An EMD on new construction is negotiated with the builder. Some builders demand up to a 50% EMD for a new home, especially if it’s customized to your specifications. This is a way for the builder to make sure you’re serious about following through with the transaction. If you back out for reasons not covered by your offer contract, you could forfeit some or all of that deposit.
Don’t risk your money: The risk of having to forfeit your EMD is why putting down a large deposit can be risky. You should determine your EMD offer by working closely with your real estate agent. A quality agent will be well-equipped to help you put down the optimum amount and make sure you’re doing everything possible to protect your money.
Earnest money deposit versus a down payment
An EMD is not a down payment. To define each simply:
- Earnest money deposit: An EMD is usually between 1% and 9% of the home’s price and is deposited into an escrow account at the time you enter into the purchase contract with the seller.
- Down payment: A down payment is typically between 10-20% of the final purchase price and is made at closing as part of the financing agreement with your lender.
Your EMD will generally be credited as part of your down payment at closing.
Who receives and holds earnest money deposits?
You should never be required to hand an EMD check directly to the seller. Instead, expect to transfer the money to a third-party firm that provides real estate escrow services.
Make sure the earnest money is held with an escrow company whose reputation and licensing you can easily check. Your deposit money should always be held in a trust account, maintained separately from other accounts.
Deposits in escrow stay safe
An escrow company is a neutral third party that will hold your EMD funds until the sale is closed, or until it’s determined which party has a right to funds according to the terms of the agreement.
Once your EMD gets deposited, either you or the seller may have access to the deposit, but only under specific circumstances related to the transaction.
In a successful transaction, the funds will typically be credited toward your down payment or closing costs as part of the payment to the seller. In the event of a dispute regarding the funds, the escrow company will hold the funds until the dispute is resolved.
Again, escrow services are neutral firms in this transaction. They can’t resolve disputes or decide who gets the money. That decision will depend on the legal system in your state.
When earnest money gets released
If your real estate transaction goes smoothly (i.e. all the provisions of your purchase agreement are satisfied), your earnest money should be credited back to you by the escrow firm at closing.
That credit will be used to offset your down payment and other closing costs and will show up on the settlement statement.
If you cancel the purchase agreement for a valid reason, as covered in your purchase contract, your deposit will usually be returned to you in full.
How you can protect your earnest money deposit
While most residential real estate transactions go smoothly, snags in the home sales process are a fact of life, and they can derail your deal.
You should avoid backing out of a deal for reasons not covered by your purchase contract. If you do, you may have to forfeit some or all of your EMD.
Here are a few ways to avoid the possible loss of your earnest money:
Understand your purchase agreement
It’s critical you know what your contract covers in detail. This is why we recommend engaging a top real estate agent or attorney when entering into a purchase transaction. (Remember that mortgage, title, and escrow companies can’t provide legal or real estate purchase advice.)
Your contract should provide all parameters for getting you to the closing table, plus the terms under which your EMD will be credited back or returned to you. Don’t be afraid to ask questions about anything you don’t understand.
If your state’s law allows it, ask to have the purchase agreement terms added, changed or removed according to what you believe is fair.
Keep in mind most contracts don’t have a “cold feet” clause so you can’t simply back out of the agreement because you change your mind.
Get pre-approved for a home loan
Once you’re under contract, you only have a certain amount of time to get to the closing table before the deal expires and you risk losing your EMD.
Mortgage financing can be complicated and cause unnecessary delays, so it’s a good idea to have yours in place before making an offer.
That’s where the pre-approval comes into play. A pre-approval is stronger than a pre-qualification, and having one gives you confidence in the size of loan you qualify for, and makes you more appealing to sellers because they know you probably won’t have financing issues.
Having a pre-approval doesn’t mean your mortgage is a sure thing, but it certainly helps. The reality is, most lenders don’t fully underwrite you before issuing a pre-approval.
So if they discover something that wasn’t taken into account during their pre-approval process, you could ultimately be denied financing.
Another reason you could lose your financing? If you make certain financial mistakes or your conditional lender approval expires.
Be sure to keep an eye on your spending, avoid taking out additional credit while the transaction is pending, and be mindful of important dates for the process to ensure a smooth approval with your chosen lender.
Make an offer on the proper home for your needs
Some home purchases can put your deposit at risk more than others.
Buying a home at auction, buying a home in “as is” condition (or with very unique features), or choosing a home that is just too far over your budget can lead to deposit woes.
Before putting a purchase offer and EMD on a house, make sure it’s the right home to fit your needs. This can often save you grief in the long run.
Avoid making multiple purchase offers
In a hot market, you might be tempted to make multiple offers. However, playing this numbers game could be legally and financially risky.
In some states, this could violate the good faith and fair dealing covenant in contracts, especially since your deposit is only valid for one contract.
What happens when more than one offer gets accepted, but you can only afford one home? You could end up in real financial trouble. Worse, you could find yourself in a costly legal fight you can’t afford.
Shield your deposit with contingencies
Most purchase agreements contain contingencies to ensure critical aspects of the transaction are successful.
A contingency means the closing of the transaction will be contingent upon certain contract terms being satisfied. Some common contingencies are financing approval, appraisal value, and satisfactory home inspection.
If contingencies are in place but can’t be satisfied, you should still be able to have most or all of your EMD returned to you.
When you’re competing for a home or just tired of shopping, it’s tempting to eliminate contingencies to push a sale through. Sometimes sellers will pressure you into making that choice to close the home sale faster. However, it’s not a smart strategy unless you’re 100% sure the closing will happen.
While it’s sometimes possible to get your EMD back after certain contingencies have been waived, it can make the task significantly harder.
If one of those waived contingencies ends up being the reason you have to back out of a contract—for example if you are unable to obtain sufficient financing after waiving a financing contingency—there goes most or all your deposit.
Research contingencies and add the ones you need to your purchase agreement. Talk to your agent about any and all contingencies and only consider waiving them if you are very confident your transaction will close and you’re comfortable risking your EMD.
Choose a lender with an earnest money guarantee
Compare lender options and ask each prospect how they plan to help you protect your EMD. A few lenders offer an earnest money guarantee.
Pay attention to purchase agreement timelines
A seller wants to get their home off the market as quickly as possible. That’s why they expect EMDs and write timeliness clauses into offer contracts. A timeliness clause essentially means if you don’t close on time and the fault is yours, you could forfeit your EMD.
Triple-check the timeline. Make sure you know what financing you’ll need and what could affect final approval.
Put contingency terms and time limits like inspection and appraisal completion on your calendar. Track all deadlines carefully to avoid defaulting. This will help you close on time with your EMD secured.
Raise issues early
Life happens, and sometimes delays are inevitable. If you think you’ll have an issue meeting purchase agreement terms or timelines, talk to your real estate agent as soon as possible.
See if they can negotiate flexibility with the seller to avoid purchase agreement cancelation. And be sure to get any contract changes in writing.
Void purchase agreements correctly
Sometimes buyers think if one of their contingencies kicks in, canceling the sale or the seller backs out for some reason, the offer contract voids automatically. That’s not true in every state and it’s best not to take a chance on the unknown.
Talk to your real estate or legal professional to make sure the cancelation clause in your purchase agreement is specific and enforceable. Then cancel it in writing according to those terms and local real estate laws.
And never sign a document canceling the sale until you’re sure how much of your EMD you are due back.
Check your state and local laws about earnest money deposits
This article should help you begin your research on EMDs and how to protect your deposit, but it’s important you understand the laws and customs specific to the market you are interested in.
Real estate law is complicated, and sometimes, a state or locality has obscure laws related to EMDs. Qualified real estate or legal professionals are your first line of defense for protecting yourself from earnest money deposit trouble. Use them early, often, and wisely.
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