What Is Earnest Money – The Definitive Guide

If any of you have bought or sold a house before, or are currently going through the home selling or buying process, you have probably heard about earnest money.

But what is earnest money? 

Is it a handful of money just thrown at the seller to keep? 

How much should the Seller ask for? 

Earnest money is usually the very first step in your new real estate contract. Make sure you are prepared to give the specified sum of money before you go through with signing any agreement.

Earnest Money Definition

In layman’s terms, earnest money is a sum of money, usually around 1% of the listing price, that is given from the buyer in the form of a personal check, cashiers check, or wire transfer, which is held in a separate trust account until the transaction is completed. 

The sole purpose of the earnest money is to assure the seller that the buyer is serious about purchasing the house.

Or as I like to say: It’s like a buyer’s “security deposit”.

It essentially makes sure the buyer has skin in the game and is not going to just waste the seller’s time.

This is how you will see it on the Colorado Contract to Buy and Sell Real Estate (Residential)

[Section 4.3] Earnest Money. The Earnest Money set forth in this Section, in the form of a check, will be payable to and held by (Earnest Money Holder), in its trust account, on behalf of both Seller and Buyer. The Earnest Money deposit must be tendered, by Buyer, with this Contract unless the parties mutually agree to an Alternative Earnest Money Deadline for its payment. The parties authorize delivery of the Earnest Money deposit to the company conducting the Closing (Closing Company), if any, at or before Closing. In the event Earnest Money Holder has agreed to have interest on Earnest Money deposits transferred to a fund established for the purpose of providing affordable housing to Colorado residents, Seller and Buyer acknowledge and agree that any interest accruing on the Earnest Money deposited with the Earnest Money Holder in this transaction will be transferred to such fund.

Earnest money vs down payment

Before we go any further it’s important to note that earnest money is NOT a down payment. Earnest money is essentially a security deposit for a home purchase between a buyer and seller, whereas a down payment is a sum of money given towards a loan in an effort to decrease the interest rate and monthly payments.

How Much Earnest Money Should You Ask For?

If you are a seller, earnest money is your security in case the buyer should default in any way. Usually, a seller asks for around 1% – 2% of the listing price, but you can really ask for any amount that you believe your time is worth.

Keep in mind the higher amount of earnest money you ask for, the more cash the buyer has to bring out of pocket from the very beginning. 

The goal is to ask for enough to deter looky-loos or serial offerers, but keep it low enough to not scare a serious buyer.

When is earnest money due

Now that we know what earnest money is, when is it due?

In a real estate contract, there is a deadline named “Alternative Earnest Money Deadline”, or something similar. This tells you when you need to turn the money into the closing entity, whether that be the listing agent, title company, attorney, etc.

Usually, earnest money is due the first week after a contract has been established, but make sure to read your contract to make sure what is the exact deadline date.

What if I don’t have earnest money

Even though the rule of thumb for earnest money is 1% – 2% of the listing price, it is negotiable. If you cannot come up with the amount asked on the listing you can negotiate with the seller and come up with an agreement for a lower amount. 

If you do not have any money to place as earnest money, then you might want to consider waiting to purchase a home until you have saved enough to have an earnest deposit.

Proof of earnest money deposit

After you have deposited (or handed in) your earnest money to the closing entity, you will be given an Earnest Money Receipt. Keep this receipt for your records in case you end up in litigation over an earnest money dispute.

Is earnest money refundable

Yes and No. Earnest money is there to assure the seller that you are serious about the purchase. If you default in any way, this is grounds for the seller to keep your money. 

This being said, there is a myriad of ways to legally get out of a contract and to get your earnest money refunded.

  • Title

If you go through the title period and find that there are discrepancies, such as liens, special assessments, encroachments, etc, these are all viable reasons to legally cancel the contract and get your earnest money back.

  • Owners Association (HOA)

With any home that belongs to an HOA, it is required that you are given the HOA Docs to review before closing. This Deadline is put in place so you can get out of the contract and get your earnest money back if there is something in the HOA you do not like. 

For Example: if you need a place to park your RV Camper, but the HOA has a rule against campers being parked at your property, well that is obviously not going to work, and you may cancel the contract and get your earnest money back.

  • Loan

If for any reason the loan falls apart and cannot get approved, the contract can be canceled and earnest money refunded, because, without a loan, the purchase can’t continue. 

Note: this is only valid if a loan is being used. If the property is being bought with cash, this is no longer a valid reason to cancel a contract.

  • Appraisal

First off, what is an appraisal? An Appraisal is how the lender verifies the worth of the house you are about to purchase. So what happens if the appraisal comes in lower than the contracted purchase price?

If this happens, it means the lender will not give you a loan for the full amount, and you will have to come up with the rest out of pocket.

For example: If you are under contract for $300,000 and the appraisal comes in low at $280,000, this means you will have to pay $20,000 out of pocket.

Because most people probably cannot do this, you can cancel the contract and get an earnest money refund without any repercussions.

Note: if you are purchasing a home with cash, an appraisal is not necessary because there is no loan involved.

  • Inspection

During the inspection phase, this is your time to find anything wrong with the property and have it looked at, repaired if necessary, or ask for money.

Ways you may ask for money

      • Price reduction
      • Seller Concessions
      • Written check to a contractor

If for any reason the seller tells you they will not fix an item you asked for, this is grounds to cancel the contract and get your earnest money back.

Note: If the seller refuses to fix an item you asked for, you may still continue with the contract. But also note that if the item was not fixed by the seller, then it is up to you to fix it.

  • Insurance

If for any reason you cannot get insurance for the new property you may cancel the contract and get an earnest money refund. 

For example: If you are trying to get insurance and you find out it is in a floodplain and the insurance company says they cannot insure the property. You can get your earnest money back.

An easy way to get around this, though, is to ask the current owner what insurance company they are using and try to get your insurance through them.

When can a seller keep earnest money

The seller can keep your earnest money if you default on the contract in any way. If there is nothing wrong with the property, and the seller has fixed all the issues you had, but you still decide to end the contract with no contingencies left, the seller will then be entitled to keep your money.

Conclusion

Still confused? I hope not. Earnest money is very simple. Just think of it as a buyer’s security deposit for the purchase of a home. Earnest money will also be applied to your purchase, which makes it not another expense. If you have any questions about earnest money, leave a comment below. I would love to help.

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