What is the Purpose of Earnest Money?
/You've found the perfect house and you are ready to write an offer. As you sit down, the very first thing your agent asks you is how much earnest money you want to put down. Um, what? What is earnest money? Why is it the very first part of the purchase contract? How much earnest money should I put down?
These questions come up all the time. Keep reading and we'll discuss the purpose earnest money plays in a transaction and also how much is appropriate to deposit.
What is Earnest Money?
You will often hear that the earnest money you put down with your offer shows the seller how "earnest" or serious you are about your offer for his home. This is true, but it is not its main function. Earnest money is the liquidated damages in the contract in the event of a default.
What's a default? Essentially it means that either the buyer or seller has cancelled the purchase contract outside of what is prescribed in the contract. There are contingencies built into the contract that allow for cancelations for specific reasons (i.e. Due Diligence, Financing & Appraisal Contingencies). If a buyer cancels as allowed in the contract, the buyer gets the earnest money back. If the cancelation is outside of the allowable reasons the buyer is considered to be in default.
In section 16 of the purchase contract used in Salt Lake, it spells out what the parties can do if the default occurs. If the buyer defaults the Seller has the option of keeping the earnest money as liquidated damages, suing the buyer to enforce the contract, or pursuing any other remedies available at law. The most common choice is keeping the earnest money.
On the flip side, if the seller defaults the buyer can also sue or pursue other legal remedies or, in addition to getting his earnest money back, the seller also pays him an amount equal to the earnest money deposit.
Knowing this function of earnest money helps to determine how much of it you should put down.
How much Earnest Money should I put down?
You want your earnest money to be enough to make both the buyer and seller weigh the decision to default on the contract seriously. You also want the seller to take your offer seriously. Here in Salt Lake City, 1% of the purchase price is a very typical earnest money deposit. So if you are buying a $300,000 house, you would put down $3,000.
That being said your check will get cashed so it must be funds you have available. If you don't have a full 1% in cash to put down, do what you can. I've had buyers using a Utah Housing Zero Down loan program put down $500. This is typically on a house that is priced below $200,000 though.
There are times when more earnest money is a good idea too. This spring was a hot Seller's Market and many homes had multiple buyers competing to purchase them. In this scenario, it can be a good idea to up the amount of your earnest money to help nudge your offer out in front of the others.
What does my agent do with my Earnest Money check?
(Quick side note - I've been saying "check" this whole time. Your earnest money can be in the form of a personal check, cashier's check, or wire transfer. Cash is usually not encouraged as it's difficult for your lender to document. It's just easier to type check so I'll keep doing that.)
In the very first section of the purchase contract, it states that the earnest money will be deposited into the Brokerage's Real Estate Trust Account. If you are my client you would write a check out to Plumb & Co. and we would deposit in our Trust Account until the contract is either cancelled or completed. Brokerages must follow very strict laws regarding the keeping of your earnest money.
Some buyers elect to have the Title Company they are closing with hold the earnest money in their Trust Account. That's okay too. I don't typically advise that direction because if the contract is cancelled sometimes the title company will require extra signatures before releasing the earnest money even though the contract doesn't require the signatures. That doesn't happen when the money is kept with my Brokerage.
The first section of the contract also stipulates when the earnest money is required to be delivered. There are two options there. 1. The money is delivered with the offer or 2. The money is delivered no later than four calendar days after the offer is accepted. Once the earnest money is delivered the brokerage has four days to deposit it into the Trust account.
Again, it is deposited so the funds must be available.
If I cancel my offer what happens to my earnest money?
In the course of your inspections, appraisal, and loan approval process you may have to cancel your offer. Each contingency in the contract has a deadline. If you cancel as allowed in the contingency before the deadline you will receive a refund of your earnest money. If you cancel outside what's allowed you may lose your earnest money as I talked about above when defining earnest money.
What happens to the Earnest Money after closing?
When you close on the house your earnest money will go towards your down payment or closing costs. For example, if you're buying a $300,000 house and you put $3,000 down in earnest money that $3,000 will be part of your down payment at closing. If you are putting $60,000 down, you would only need to bring $57,000 to the closing because you've already given the $3,000.
Earnest money is an important part of the home-buying process. If you have more questions about it, please let me know.
Also, if you or anyone you know has any real estate needs, give me a call today.