Everything You Need to Know About Earnest Money Deposits
What is an earnest money deposit? How does an EMD differ from a down payment? Where does an earnest money deposit go and why is it important?
Both earnest money deposits and down payments are critical parts of the home buying process, but they are definitely not the same thing. However, in both cases, the more money you can offer, the better your chances may be of getting the home you want. So, what is the difference? Let’s discuss.
Let's go into depth about the terminology before we continue!
To read more about this topic, check out these blogs:
- What makes up a mortgage payment?
- 7 Reasons why every home buyer needs title insurance
- What is escrow?
What is an EMD?
To show a seller that an offer is serious and made in good faith, a prospective homebuyer will include a check with their offer, for typically 1-2% of the purchase price. This is known as the “earnest money deposit” and is an integral part of a buyer’s offer. The seller may get to keep that money if the buyer pulls out of the deal for a reason that isn’t allowed under the purchase contract, such as the buyer simply changing their mind after the contract is ratified. A strong earnest money deposit essentially acts as security and incentives the seller to accept an offer and take the home off the market versus waiting for offers from additional prospective buyers.
If the seller has several offers, a larger earnest money deposit could set you apart from the competition. For more expensive properties, your real estate agent might be able to negotiate a lower deposit. As a general rule, earnest money is worth as little as a seller is willing to accept and as much as a buyer is willing to offer.
Always make sure you have the money in the bank before you submit a check with your offer. The earnest money deposit is typically turned over to the title company after the contract is ratified and they will cash it shortly thereafter. The money is placed in an escrow account until closing. If the deal goes as planned, the earnest money is usually applied towards your down payment. In the event you negate the contract due to one of the contingencies in your offer, such as the results of the home inspection, your earnest money deposit will usually be returned. Make sure you read your refund agreements carefully.
What is a down payment?
The down payment is the amount of money that the lender requires you to put towards the purchase of the property. Normally based on a percentage of the total sales price, the amount is typically established early in the loan application process with your lender. While down payment amounts can vary from 3.5 percent for an FHA loan to upwards of 20 percent for certain conventional loans, normally the source of the money must be verified and approved by the lender. (For more information on this, we recommend reaching out to firstname.lastname@example.org and we can put you in contact with our preferred home mortgage companies)
With a higher down payment, your chances of getting approved for a mortgage are higher. In addition, you will have a smaller monthly mortgage payment and more equity in your new home.
What are three scenarios in which you could end up losing your deposit to the seller?
1. You Waived Your Contingencies
In highly competitive markets, it’s becoming more common for buyers to waive contract contingencies regarding financing or an inspection. You might be tempted to do the same if you’re really after a particular property. It will make you a more attractive buyer, but it also comes with serious risks. You guessed it, you might lose your earnest money deposit.
The financing contingency guarantees that you will get your money back if the financing is not approved. With the inspection contingency, you can declare the contract null and void (and get your deposit returned) if there are issues uncovered in the home inspection that make you change your mind about purchasing the home.
If you waive all your contingencies and there are financing or home defect issues, you will not be able to get your deposit back if you abandon the deal. Therefore, you may not want to waive the inspection contingency unless you’re planning on tearing the property down. Or, if you think you will be in a competitive offer situation, you could do an inspection before submitting an offer. That way you know ahead of time if there are any serious issues with the home that would prevent you from purchasing it, and can submit an offer with the home inspection contingency waived. As for the financing contingency, waiving it may be the only way to compete with all-cash buyers. However, you have to be absolutely sure that you’ll be able to get approval from the bank.
2. You Ignored the Timeline Outlined in the Contract
Your contract usually sets specific time frames in which you need to secure financing and do any inspections. If you try to void the contract after any of these deadlines have passed, you could lose your deposit. Generally speaking, as long as you’ve made a good-faith effort to adhere to the timeline, sellers will grant a reasonable extension if the lender needs more time or there are other extenuating circumstances that delay things. Any extension must be made in writing and signed off by both the seller and the buyer.
3. You Get Cold Feet
If you have a change of heart about the home you’re buying, but there’s no problem with the property or the financing, you likely will not get your deposit back. The earnest money deposit serves as protection for the sellers when they take their home off the market. If late in the game you decide that you no longer want to make the purchase, they get to keep it as compensation for the time and money they have to spend on listing their home again and looking for another buyer.
However, if you do change your mind, you may not be limited to losing the deposit only. The sellers could sue you for specific performance and all the tertiary costs that go with that, including their legal fees. For instance, let's say the sellers moved out of the house and that they staged the home by bringing in additional furniture. When the house goes under contract, they move the furniture out so that they don’t incur further staging costs. If the buyer backs out due to cold feet, think of the additional costs that the seller now bears, which could be more than the cost of the deposit. You could be responsible for these costs as well, so be careful.
In Eric Stewart's Words:
"From personal experience, I have a fourth scenario in which buyers could lose their deposit. This is if they don’t represent their financial situation truthfully. Last year, buyers who ratified a contract on a listing I had committed fraud. They represented their ability to purchase the home based on income and assets that were not real. They put up a $25,000 deposit on a $690,000 purchase in McLean. We went after that $25,000 and got 100% of it for the seller. The seller ended up putting the property back on the market and actually came out slightly ahead because of the deposit, but nobody wants to go through the pain and aggravation of all that, right? Of course not. When you're a buyer and making an offer, make sure you represent yourself honestly."