Earnest Money: What It Is, Why It’s Important — and How to Protect Your Deposit
(This post on earnest money is based on a section from The Book on Rental Property Investing. If you are reading this post, you really should probably pick up a copy of that book.)
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When you join the mob, they likely will ask you to kill someone, just to make sure are serious and not wasting their time.
In real estate, people also hate to have their time wasted. Lucky for us, though, murder isn’t required to prove our sincerity.
Instead, we rely on the earnest money deposit.
The earnest money deposit, also known as a good faith deposit or simply earnest money, is money provided by the buyer when an offer is submitted as a way of showing the seriousness of the offer. This deposit is essentially the buyer saying, “Look, I really want to buy this property, and I’m putting my money where my mouth is.”
The earnest money is pledged, and should the buyer not fulfill his end of the contract, the seller can keep the money. So yes, you can lose your earnest money! However, there are certain conditions that allow you to back out without losing it, which we’ll talk about.
But first, let’s talk about how much the earnest money deposit is.
How Much Is the Earnest Money Deposit?
The amount of earnest money supplied depends greatly on the price of the property and the person from whom you are buying the property. For example, the earnest money on a $40,000 house will probably be far less than the earnest money on a $1,000,000 apartment complex!
Although there is no hard and fast rule that governs the amount required, most earnest money deposits tend to be 1% to 2% of the purchase price.
Because the seller gets to keep the earnest money if the buyer backs out without a legitimate reason (which we’ll talk about in a moment), the higher the earnest money deposit, the better the chance that your offer will be accepted.
That said, when dealing with motivated sellers, the earnest money becomes much less “normal” because the seller generally doesn’t know or care much about the amount. Some investors simply make the earnest money $1.00, and most private sellers don’t seem to notice or mind.
When Is the Earnest Money Deposit Given?
One of the most common questions I am asked on our weekly BiggerPockets Webinar is, “How do you make so many offers? Where do you come up with all that earnest money?”
You see, this question is based on a false belief that earnest money is given when the offer is made. However, in most cases, the earnest money is not given until AFTER the offer has been accepted. So, I can make 20 offers in a month, but if only two of those get accepted, then I only have to pay earnest money on two of them.
For more on my offer strategy, don’t miss How (and Why) I Offer on Properties BEFORE I Ever Step Foot in the House.
Who Holds On to the Earnest Money Deposit?
The earnest money should not be given directly to the seller (unless it’s something small, like a dollar).
Instead, this money is usually held by a third party, most likely the title company or attorney who is handling the closing. This ensures that the rules that govern what happens to the earnest money are followed. This is most commonly done when the contract has been accepted and signed by both parties, not before.
If you are working with a real estate agent, your agent will mostly likely tell you when and where to drop off the earnest money check.
What Happens to the Earnest Money?
So what exactly is the earnest money used for? What ultimately happens to it? There are three possible scenarios that could play out, depending on how the deal is done (or not done).
- If the sale goes through, the earnest money becomes part of the cash the buyer would be required to bring to closing. For example, if your down payment plus closing costs came to $50,000 but you gave a $2,000 earnest money deposit, you would only be required to bring $48,000 to the closing table, as directed by the title company or attorney who closes the sale.
- If the sale does not go through and the buyer does not have a legal reason to back out, then the deposit is forfeited to the seller, and the seller receives the deposit.
- If the sale does not go through and the buyer does have a legal reason to back out, the deposit is returned to the buyer.
So what are these “legal reasons” I have mentioned? They are known as “contingencies.”
Real Estate Contingencies
Most contracts, real estate or otherwise, contain certain provisions that outline conditions in which the contract could be terminated. These provisions are known as “contingencies.” In other words, the property sale is contingent on some specifically listed things.
These are legal loopholes that allow you to not follow through on your contract, should one of those contingencies happen to occur.
Technically, you could have contingencies for anything you can think of. Yes, that means you could write up a contingency in the contract that says, “This contract is contingent on the grass being colored purple” or “This contract is contingent on my hair falling out before closing.” If you were to include those and the grass was NOT colored purple or your hair did not fall out, you could cancel the contract and back out with no repercussions. Of course, these are absurd examples meant only to illustrate what a contingency is.
So what kind of contingencies should you put in your offer?
First, understand that the more contingencies you put in your offer, the more leery a seller will be to accept it.
Think about it: If someone offered to buy your home but only if 50 little contingencies happened, would you feel comfortable accepting? Probably not!
However, at the same time, contingencies are often necessary to protect yourself from things you couldn’t anticipate — like knowing how much to offer, knowing which contingencies to include in the contract depends on the deal itself and the person you are submitting the offer to. If I was competing with numerous other people for a property, I might include far fewer contingencies than I would if I were offering on a deal with no competition.
But let me share the two most common contingencies you’ll likely encounter:
1. The Inspection Contingency
You can only learn so much about a property by walking through it on a quick tour. As I’ll talk about more later in this book, it’s pretty important to do a deep inspection of a property before buying it, using a professional inspector to find every imperfection they can about the property.
An inspection contingency, therefore, gives you the ability to inspect everything about the property within a certain timeframe and back out if you find something that you didn’t expect. On residential homes, a 10-day inspection contingency is most common. This means that after 10 days, the contingency is no longer applicable.
Inspection contingencies are very common in real estate contracts, but some experienced investors do choose to waive this contingency, opting instead to take the risk that nothing unforeseen will come up in the inspection. If it does and they have to back out because of it, they could lose their earnest money. Other investors, including me, often designate much shorter inspection periods (often as brief as three days), knowing that this will still allow time to get in and get the property looked at in detail, but it will look better than those who need ten days. (Of course, you need to know that you can get it inspected in this timeframe. Often, professional inspectors are booked out several days in advance and take a couple of days to get the report to you.)
2. The Financing Contingency
What would happen if you tried to buy a property but at the last minute, you found out that your financing had fallen through? As disappointing as that might be, you might also lose your earnest money if you don’t have the financing contingency in place. The financing contingency allows a buyer to back out and to keep their earnest money should the buyer not be able to obtain a loan.
Of course, if you are paying cash for a house, you will have no need for a financing contingency, and your offer will likely look much stronger to the seller. Some investors choose to avoid using the financing contingency, even if they are using a loan. This can help make their offer stand out, because the seller knows that either the deal will close or they’ll get the earnest money, no matter what happens.
Of course, if you choose to waive the financing contingency but still plan to use a loan, this can increase your risk of losing that earnest money should something go wrong with your financing.
So, what other questions do you have about the earnest money deposit?
Share your questions or comments below and let’s talk!
Oh — and don’t forget to sign up for this week’s webinar!