Attaching a check to the offer on a house you hope to purchase is the right way to signal your intentions to the seller. The larger the check, the more serious the buyer.
But putting up earnest money is not without risk. If you don’t abide by the contract you and the seller sign, you could end up forfeiting the entire amount.
Margaret Goss, an agent in Winnetka, Illinois, has had only one client lose their earnest money, but it was a doozy. Goss commented – on an ActiveRain article on the topic, written by agent Bill Gassett of RE/MAX Executive Realty in Hopkinton – that when closing day came for this client, they backed out.
“The market was changing and they felt they had paid too much,” said Goss. “They lost a bundle.”
More on that in a moment. First, some basics.
Earnest money isn’t the same as a down payment. A down payment is the amount lenders require borrowers to put into the transactions up-front so that the bank can feel secure in financing the balance of the home’s cost. In other words, if you bring, say, 10 percent of the purchase price to the closing table, the lender will hand over the other 90 percent.
In contrast, earnest money is a sign of good faith to the seller. It tells the seller you intend to move forward. It can range from as little as $500 in some markets to several thousand in others, and usually increases when competition for houses is strong.
Your earnest money can be rolled into the down payment when you sit down at closing – but it also can be lost if you fail to reach that point. You have to follow the letter of the contract. And timing is everything – especially when it comes to any contingencies written into the document.
Contingency clauses protect both buyer and seller. But the more contingencies, the greater the possibility of the deal falling through. So in competitive markets where houses are flying off the proverbial shelves, some buyers are forgoing home inspections and other protections in order to present sellers as clean a deal as possible.
Buyers, Protect Yourselves
It always behooves buyers to protect themselves against unforeseen circumstances, but contingencies can cause trouble if you run out of time. Most real estate contracts include timelines that must be adhered to by both buyer and seller.
Take the home inspection clause, for example. Usually, the number of days you have to order the inspection and receive a complete report of the findings is agreed to by both parties and written into the contract.
If the inspector finds defects you don’t want to deal with, you can back out of the purchase and your earnest money will be returned. Here, advises Gassett in his ActiveRain post, you should notify the seller that you want out, in writing, prior to the expiration of the inspection contingency.
If you miss the deadline, either because the inspection wasn’t completed in time or because you failed to notify the seller that you are no longer interested, the seller can keep your deposit.
The same holds true for the mortgage contingency. Cash buyers don’t have to worry about this, but most people need financing, so they write into the contract how many days they have to secure a loan. Sometimes, a maximum interest rate is also specified.
That’s one reason smart buyers get themselves preapproved by a lender – not just prequalified, but preapproved for a loan up to a certain amount. Then, when they find a place they want, they can move quickly. But again, if you miss the deadline – or fail to tell the seller in writing that you are unable to secure a loan – you can lose your deposit.
The seller can grant a mortgage extension if you want to keep hunting for a lender, but Gassett suggests getting that permission in writing.
Another contingency to keep in mind involves the appraisal. This protection allows you to walk away if the selling price turns out to be more than what the appraiser said the property is worth. Like the others, this contingency comes with a timeline.
Contingencies Not Foolproof
If, during the post-contract, pre-closing period, you simply change your mind about the house, you can sometimes use one of the above contingencies to back out of the deal. If the seller is holding backup contracts just in case your deal falls through, or if other buyers are knocking on their door, they will probably let you skate.
But if you can’t demonstrate a good reason for changing your mind, they could hang on to your earnest money. After all, they’ve probably taken the house off the market and missed showing the place to other interested parties.
Now the lawyers become involved, and that could tie up your money for months – money that you might need to put up for another house. So read your contract closely and follow it carefully.
One last word on earnest money, which also applies to deposits on new-build homes: Make certain the money is held in a dedicated escrow account. Some financially strapped homebuilders have mingled customers’ deposits with their own operating funds – and when the businesses went under, the money was gone.
Lew Sichelman has been covering real estate for more than 50 years. He is a regular contributor to numerous shelter magazines and housing and housing-finance industry publications. Readers can contact him at email@example.com.