When you find your dream home and put a bid on it, you may want to include earnest money deposits as an option. This lets the seller know that you are serious about purchasing the house. Before you go and offer the deposits, or worse yet, put them down, learn how to proceed. Just like gift funds, lenders require very careful verification of the deposits in order to use them for the purchase of a home.
How Much do You Pay?
Every situation is different – there is not a standard amount of earnest money you need to put down when you bid on a home. The typical amount equals between 1 and 2 percent of the purchase price. This amount will vary based on your state requirements and what the seller requires. If the real estate market is hot and demand is high, a larger amount of earnest money may be required. On the other hand, if the market is sluggish, sellers may be less likely to require as much money in conjunction with the contract.
Who Holds Earnest Money Deposits?
Generally, only the title company or real estate agent should hold your earnest money deposits. In some cases, the seller offers to hold the money, but this is rarely a good idea. If you had a reason to back out of the contract in the future, it would be much harder to get your money back from the seller than it would from the title company or real estate agent.
Where Does the Money Go?
Once you sign the contract and move forward in obtaining financing, your earnest money sits in an escrow account. Once the loan is ready to close and the seller is ready to turn over possession of the home, the earnest money counts towards your down payment. This means if you put 1% earnest money towards a home you agreed to purchase for $200,000, you have $2,000 towards your down payment. If the lender required you to put down 3.5% because you took out FHA financing, you would owe $5,000, which is the difference between the $7,000 required down payment and the $2,000 earnest money.
Documenting Earnest Money
Documenting the earnest money is one of the most important things you can do in the home purchase process. If you don’t follow the lender’s instructions, you could cost yourself more money in the end. Here are some of the most common rules:
- Always pay with certified funds. Never pay the seller with cash. The lender needs to be able to track the funds and it is impossible to track cash.
- Keep a paper trail of the funds. If you write a check, keep a copy of it. If you obtain a cashier’s check, copy it as well.
- Provide proof of the origin of the funds. The lender needs to make sure they are your own funds and not borrowed funds. If you receive a gift, you will need to obtain lender approval first and track where the money came from as well as goes.
There are certain situations where a lender will not need to source your earnest money deposits. This occurs when you have sufficient funds in an account to cover the down payment, closing costs, and the amount of the earnest money deposit. This simplifies the amount of paperwork you must provide a lender. If, however, you don’t have sufficient funds in the account, you must verify the earnest money separately from the closing cost money and/or required reserves.
Receiving a Refund of Earnest Money
Whether you will receive your earnest money back if the purchase contract falls through depends on the situation. Pay careful attention to the wording in the purchase contract and obtain an attorney’s approval before signing. This way you will know what will happen to the funds if you were to cancel the contract.
In most cases, the closing agent or person holding the funds will determine what happens to the funds. If a full refund is not allowed, you may receive a small portion of the funds, while the remainder goes to the seller as compensation for keeping the home off the market while you tried to secure financing.
Secure a Preapproval
The best way to avoid losing your earnest money deposits is to secure a preapproval for financing prior to shopping for a home. This way you know what you are eligible to receive and should hopefully prevent you from signing a contract for a home you cannot afford. The preapproval can help you put earnest money down in confidence. If anything were to fall through with the contract, hopefully it would be due to an issue with the home and not your financing. In this case, you should not have a problem receiving your money back.
Documenting earnest money deposits is just as important as documenting a down payment. If you want to use the funds as official funds towards the purchase of the home, the lender will require specific steps. Talk to your lender before putting any money down to ensure that you follow their steps and don’t miss anything. When you do it right, the money counts towards your down payment and reduces the money you must bring to the closing. This can help make the home purchase process a little less complicated for you in the end.