How to Protect Your Earnest Money Deposit
The last thing any home buyer ever wants to do is put down money to buy a home and lose it, but it happens. There are many ways to lose your earnest money deposit. If you don't understand how your deposit is handled, you should ask questions at the time you make an offer. Ask to see the verbiage in the contract that guarantees the return of your deposit. Not every purchase contract affords this type of protection.
How Much Is Required?
Typically, there is no set deposit requirement. In California, for instance, contracts must contain consideration to be valid, but that amount can be as little as one dollar. Laws in your state may be different. Bear in mind, however, that the amount of your earnest money deposit depends primarily on your marketplace and local custom.
Consider this: If you offered a seller a $1.00 as an earnest money, the seller would look at you funny and presume you are not serious. Earnest money should reflect your earnest intention to make good on your offer and purchase the home.
What Is an Earnest Money Deposit?
Earnest money is a good faith deposit that is part of the down payment but should not to be confused with a down payment. When buyers execute a purchase contract, the contract specifies how much money the buyer is initially putting up to secure the contract, to show "good faith," and how much money all together will be deposited as a down payment. The balance is generally financed as a mortgage or a combination of mortgages. An earnest money deposit says to the seller, "Yes, I am serious enough about buying your house that I'm willing to put my money where my mouth is."
So, How Much Is Enough?
Because there is no set amount, it varies from market to market and across the country. In California, for example, deposits are generally 1 to 3 percent of the sales price. Buyers here do not often put down more than 3 percent since most sign a liquidated damages clause that limits the seller to 3 percent of the purchase price as damages in the event of a default. Although, it is unusual for a buyer purchasing a $300,000 home to put down $1,000, especially if the buyer is obtaining 100% financing, like a VA loan.
In those scenarios, the deposit is most often refunded to the buyer and subsequently used as a credit toward closing cost because the financing makes up the entire purchase price.
Some recent legislation has put agents on the alert that the listing agent might not be protecting the seller if she does not advise the seller to ask for a larger earnest money deposit. This could arise in the event the buyer defaulted. A court might question why the earnest money was so low and blame the listing agent.
If it's a seller's market, with many buyers fighting over limited inventory, it makes logical sense for the buyer to put down a much larger earnest money deposit to entice the seller to accept the offer. In buyer's markets, a larger earnest money deposit might entice a seller to accept a much lower purchase price. It is often the market and local conditions that can determine the amount.
Be Careful to Whom You Give Your Deposit
When making an offer and submitting your earnest money deposit, it pays to be informed. While issues are rare, ensure you know to whom you're giving the deposit and keep the following tips in mind:
Never give an earnest money deposit directly to the seller.
Make the deposit payable to a reputable third party such as a well known and established real estate brokerage, legal firm, escrow company, or title company.
Verify that the third party will deposit the funds into a separately maintained trust account.
Obtain a receipt.
It is generally inadvisable to authorize a release of your earnest money (or a pass-through) until your transaction closes.
How Can You Lose It?
First, read your contract. Laws vary from state to state. In California, for example, standard C.A.R. purchase contracts allow for the return of the earnest money to the buyer within a specified time period should the buyer elect to cancel the transaction. If at that point the seller refused to return the deposit without cause, the seller could end up paying a $1,000 civil penalty to the buyer.
However, not every agent is a member of C.A.R. in California. And builders typically do not use a C.A.R. contract as they have their own purchase contracts.
In usual circumstances, though, upon cancellation, the sellers and buyers are asked to sign mutual release instructions. If an agreement cannot be reached, the party holding the earnest money deposit will continue to hold it until an agreement is reached. If no agreement has been reached after a few years, escrow companies then send the parties a certified letter asking for mutual instructions. The letter says if nobody responds within a certain time period, then escrow will return the money to the buyer.
If the seller contests the action then, after three years, escrow will send the money to the state of California.