The process of buying a home can be confusing, introducing a variety of terms and processes that most people rarely encounter in their daily lives. However, understanding the language and expectations that come with home buying can help you get the most out of your experience – and avoid major pitfalls that can cost you time and money.
Earnest money is a commonly used, and frequently misunderstood, concept in the mortgage process. Knowing how to plan for and utilize this resource can help you improve your home buying experience in a competitive market and secure the home of your dreams.
Earnest Money vs. Down Payment
It is common for home buyers to confuse the terms “earnest money” and “down payment.” And there's a good reason for that. Your earnest money, sometimes called a “good faith deposit,” and your down payment, serve related purposes.
Although your down payment ultimately goes to the seller, it’s primarily a matter of interest for your lender. Since your down payment reduces the size of the loan required for your home purchase, and since it may be an indication of your liquid assets, mortgage lenders like to see a deposit of 20% when possible.
Lenders consider down payment money during your loan application process and it plays a role in determining whether your application is approved. On the other hand, earnest money can be thought of a bit like a “deposit,” and it is paid directly to the seller.
While the term “deposit” may make you think of renting an apartment, and not buying a home, the function is similar. A rental deposit helps to compensate the landlord should you break your rental agreement in some way. An earnest money “deposit” compensates the seller for their time or damages if you back out of the purchase contract. This is also why this money is sometimes called “good faith” money, since it shows that you are placing money at risk as a sign of your commitment to purchase the property.
When Do You Need Earnest Money?
Adding to the potential confusion regarding the role of earnest money is the fact that not every home sale requires this expenditure. However, if you are working through a real estate agent, it should become clear early in the process whether the seller is seeking earnest money.
The amount of earnest money you’ll pay varies based on your location, but in Oklahoma, it’s typically between $500 and $1,000.
Usually, earnest money isn’t due until the contract is accepted by the seller, or shortly afterward. The reason for this timing is that, when a home is listed “in contract,” it’s typically viewed as off the market by many buyers. Therefore, if the potential buyer backs out of the contract, the seller may have missed opportunities to show the home to other prospective home buyers.
Earnest money allows the seller to recover damages and cover expenses from re-listing and showing the home after a failed contract.
When the earnest money is handed over, it is usually held “in escrow” with a third-party company (usually listed on the purchase agreement) until the home purchase is finalized. And while this may seem to add an additional expense to your home purchase, once you receive your keys, your earnest money is usually applied toward your down payment and closing costs.
Can Earnest Money Be Returned?
Earnest money is intended as a sign of commitment, but there are a limited number of circumstances in which a good faith deposit can be returned. In most cases, buyers only get their earnest money back if there is an issue with the contract provisions, inspection, or the seller decides not to sell.
For example, if the home inspection or appraisal reveal causes for concern, the buyer may be able to leave the agreement, and receive their deposit, with justification. However, if the potential buyer encounters a financial issue, or simply seeks more time than the contract allows, the money is not likely to be returned.
Making Earnest Money Work for You
Even if you find yourself in a home buying scenario where the seller doesn’t request earnest money, you are welcome to offer it. In fact, this can be a very wise strategy for increasing the likelihood of a successful home purchase in a competitive housing market.
Depending on the location or features of a home, it’s possible that the owner will be faced with multiple viable offers. And while the Fair Housing Act prohibits a seller from using discriminatory tactics when selecting a buyer, they can consider financial justifications in purchasing a home.
For example, if the seller receives an offer of the appropriate amount, but there is reason to believe the buyer will not secure the loan, the seller can refuse the offer. Additionally, if two desirable offers are made, the seller may try to assess which offer is more viable. In this scenario, offering earnest money, even if the seller doesn’t request it, could show your commitment to the seller, and tip the scales in your favor.
How to Pay Earnest Money
Although earnest money is ultimately paid to the seller, the money will be placed in escrow as the home purchase unfolds. With that in mind, don't offer to pay your money directly to the seller – this may be a risky strategy, depending on the reliability of the individual.
Instead, utilize the expertise of your lender to help you navigate this process. Once your offer of earnest money has been accepted, allow your lender to verify the amount to be paid and facilitate transfer to the closing company.
A personal check is the best form for payment for earnest money, and your lender will likely make a copy of your check to prove that you have fulfilled the commitment. However, electronic fund transfers and cashier’s checks may also be utilized in some circumstances. We don’t recommend paying your earnest money in cash, as it can’t be tracked in the future if there’s an issue or dispute.
Why does the method of payment matter? Since your earnest money can be used toward your closing costs and down payment, these funds need to be verified as earned income or “seasoned money,” just like other money you apply toward your purchase. In other words, since lenders are interested in assessing your financial stability in order to help prevent later foreclosures, they only recognize the legitimacy of certain funds – ideally, dollars that can be traced back to your employment or financial accounts.
Windfalls or other unverified funds are not considered reliable for a home purchase. Therefore, earnest money that cannot be explained would not likely count toward your closing costs or down payment.
Rather than risk this situation, always seek the advice of your lender before, during, and after the home buying process, and never be afraid to ask questions about how to manage your home purchase funds.
With a little guidance, you can make your earnest money work for you, helping you strengthen your financial situation, while making a purchase offer that will be hard to refuse! If you feel like you’re ready to take the dive into homeownership, schedule a Home Loan Coaching Session with one of Lincoln’s loan officers today.