How to Protect Your Earnest Money Deposit
The last thing any homebuyer wants to do is put down money to buy a home and then lose it, but it happens. Your earnest money deposit is an initial deposit you make when you sign a purchase agreement. In some cases, you may make an earnest money deposit when you make an offer. Unfortunately, there are many ways to lose your earnest money deposit.
If you aren't sure how your deposit will be handled, ask questions at the time you make an offer. Ask to see the wording in the contract that guarantees the return of your deposit and addresses how long it will take to get your deposit back. Not every purchase contract affords this type of protection.
What Is an Earnest Money Deposit?
Earnest money is a good faith deposit that is part of the down payment, but it should not be confused with a down payment. When buyers execute a purchase contract, the contract specifies how much money the buyer is initially putting up to secure the contract and how much money will be ultimately be deposited as a down payment. The balance is generally financed as a mortgage. An earnest money deposit says to the seller, "Yes, I am serious enough about buying your house that I'm willing to put my money where my mouth is."
How Much Earnest Money Is Required?
Typically, there is no set deposit requirement. In general, potential homebuyers put down 1% to 5% of the purchase price down as an earnest money deposit. Bear in mind that the amount of your earnest money deposit depends primarily on your marketplace and local custom.
An earnest money deposit should reflect your intention to make good on your offer and purchase the home.
Because there is no set amount, earnest money deposit amounts vary from market to market and across the country. In California, for example, deposits are generally 1% to 3% of the sales price. California buyers do not often put down more than 3% since most sign a liquidated damages clause that limits the seller to 3% of the purchase price as damages in the event of a default. An experienced real estate agent can advise you on the typical earnest money percentage in your area.
It's unusual for a buyer purchasing a $300,000 home to put down just $1,000, even if the buyer is obtaining 100% financing. Even if you're getting 100% financing, you should still put down a large enough earnest money deposit to show you're serious about the purchase. In cases of 100% financing, the deposit is usually refunded to the buyer and used as a credit toward closing costs because the financing makes up the entire purchase price.
If it's a seller's market, with many buyers fighting over limited inventory, it makes logical sense for the buyer to put down a larger earnest money deposit to entice the seller to accept the offer. In buyer's markets, a larger earnest money deposit might entice a seller to accept a lower purchase price. It's often the market and local conditions that determine how much you should offer as an earnest money deposit.
Be Careful With Your Deposit
When making an offer and submitting your earnest money deposit, it pays to be informed. While issues are rare, ensure you know to whom you're giving the deposit and keep the following tips in mind:
- Never give an earnest money deposit directly to the seller.
- Make the deposit payable to a reputable third party such as a well-known and established real estate brokerage, legal firm, escrow company, or title company.
- Verify that the third party will deposit the funds into a separately maintained escrow account.
- Obtain a receipt.
- In general, don't authorize a release of your earnest money until your transaction closes.
If anything seems fishy, talk to a trusted advisor. It's important to protect yourself and your money from potential scams.
How Can You Lose Your Deposit?
First, read your contract. Laws vary from state to state. In California, for example, standard California Association of Realtors (CAR) purchase contracts allow for the return of the earnest money deposit to the buyer within a specified time period should the buyer elect to cancel the transaction. If at that point the seller refused to return the deposit without cause, the seller could end up paying a $1,000 civil penalty to the buyer.
However, not every agent is a member of CAR in California. And builders typically don't use a CAR contract as they have their own purchase contracts. Other states may have state-mandated real estate forms.
Typically, buyers can lose their earnest money deposit if they don't follow the terms of the purchase contract. For example, the contract may specify when inspections need to be completed and when a buyer can back out of a contract. If a buyer waits to get an inspection and then backs out of the contract after the deadline, the buyer may lose the earnest money deposit.
Most of the time, when one of the parties cancels the contract, the sellers and buyers are asked to sign mutual release instructions. If an agreement can't be reached, the party holding the earnest money deposit will continue to hold it until an agreement is reached. If no agreement has been reached after a few years, escrow companies then send the parties a certified letter asking for mutual instructions. The letter says if nobody responds within a certain time period, then escrow will return the money to the buyer.