What is Earnest Money and the Good Faith Deposit?

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  Written by Ryan Shaw

The escrow process often begins with your offer to purchase a house. The money you put down to show you are serious about the purchase is known as a “good faith deposit” or “earnest money.”

The terms are used interchangeably depending on the state you live in. They both mean the same thing.

This money is deposited into an escrow account that is controlled by a third party to insure impartiality.

If the deal is successful, the deposit will go towards closing costs and other expenses for the purchase.

If the deal falls through, getting your good faith deposit back depends on your contingencies and why the deal fell through in the first place.

Knowing the right contingencies to put in place is paramount to protecting the earnest money you put in the escrow account.  

Without further ado, let’s get into the history of escrow and what it means and how you can protect your deposit in the event that the deal falls apart.

 The history of escrow and its use

The concept of using an escrow for a transaction is nothing new.  

Using an escrow for homeownership started during the Great Depression, when many homeowners were losing their homes because they didn’t have enough money to pay the big property tax bill at the end of the year.  

As a result, lenders began collecting 1/12 of the anticipated tax bill every month as a sort of “forced savings” and they put the money into an account that was used to pay the tax bill every year.

By 1934, all FHA insured loans were required to collect tax funds via escrow, and over time it became a standard practice across the entire mortgage lending industry.

When you are dealing with a mortgage company and they mention the word “escrow,” this is probably what they are referring to.

The other situations that call for putting money into an escrow account is when an offer on a house has been accepted.  

When you put money into an escrow account after making an offer–this is known as a “Good faith deposit.”  It’s also known as “earnest money.”

The main concern your are thinking about is putting an offer on the house and what happens to your money in the event the deal does or does not work out.  That’s a lot of money you’ve put up–you need to know what can happen.

How Much Earnest Money Should I Put Down?

In order for a contract on a house to be valid, there needs to be at least some money put behind the offer.

This money is your sign to the seller that you are serious about purchasing their house and moving forward with the deal.

In highly competitive markets, the earnest money deposit can be used to stand out among the crowd of buyers. The more you put down, the more serious the seller will take your offer.

Of course, the ultimate way to stand out to a seller is to be a cash buyer.  If you’re not fortunate enough to be in that position though, a sizable earnest money deposit is a good alternative.

You can expect to put down anywhere from 1%-10% of the price of the home down as your earnest money deposit.  Sometimes, you can get away with putting down as little as $500 depending on how hot the market is in your area.

Under normal conditions, you’ll want to put between $1K-$3K into an escrow as your earnest money deposit.

Of course, once you write the check, it goes into an “escrow” account that holds the money until the sale is finalized.

Who chooses the escrow company?

Depending on your state’s laws, the broker your buyer’s agent works under will have an escrow account or it could be the title company that holds the money in escrow. Sometimes you will be working with a third party known as an “escrow” officer.  

If it’s being outsourced to a third party, be sure to check their credentials and make sure they are legitimate.  If you can, it’s best to work with someone your agent has used before in the past or a trusted title company.

It’s also super important to remember to never give the earnest money directly to the seller.  If something goes wrong, it can be a nightmare to get the money back.  A third party is much more likely to be impartial and give your money back if the deal goes south.

Most of the time, you won’t have to worry about this if you are working with an agent.

If you are buying a house without the assistance of a real estate agent–make sure you do your homework on the escrow company.

Using Contingencies to Protect Your Earnest Money

A contingency in a real estate deal is a condition that must be met for the buyer to proceed with the deal, or they can cancel the contract.  Here are some common contingencies that buyers use to protect their deposit.

Appraisal

An appraisal contingency allows for the buyer to exit the deal if the house not not appraise for the price that both parties agreed on.  

Home Inspection

An inspection contingency states that the buyer can exit the deal if the inspection report does not meet their satisfaction, and the seller does not make the necessary repairs.  As the buyer, you have a certain period of time after you receive the inspection report (typically around 10 days) to either approve the report and move forward or bring up any issues you have with the condition of the house. There are various forms of the inspection contingency so read it carefully ,some have a dollar number that the seller agrees to in advance to spend on repairs.

With most “AS IS” with the right to inspect contracts,as the buyer you can simply state in writing

that the inspection “did not meet my satisfaction” and you can get your earnest money back if you’re within the time allotted to do so.  

Financing

Another extremely common contingency is for financing.  A contingency for mortgage approval allows the buyer to cancel the deal and get their earnest deposit refunded if they are unable to qualify for a mortgage.  

Selling Your House First

Often times you are shopping for your next house while your current house is on the market.  You may have a pending deal on your house that you need to sell before you can go on to buy your next house.

In this situation, you can make an offer contingent upon you selling your house.

If the deal on your house doesn’t close, you can get out of the contract.

When do I lose my Earnest Money?

Hopefully everything goes swimmingly during your deal and you never have to face to possibility of needing to get your earnest money back and cancelling the deal.

If you’ve mastered the art of negotiation up until this point, you’ll have built up a solid amount of rapport with the seller rather than a sense of competition.

That sense of partnership is no more important than when you need to get your earnest money refunded and walk away from the deal.

If you were diligent about adding in contingencies when you signed the deal, you can probably use one of them to cancel the deal.

The common errors that buyers make that may cause them to lose their earnest money:

You waived your contingencies

It may be a super competitive market where you live–and you might be tempted to say “screw it” and waive some or all of your contingencies.  This could put your earnest money in jeopardy.

Once you waive your contingencies–all bets are off.  You are either buying that house or you are losing your cash.

Deal fail rates are hard to come by in the U.S. as the MLS doesn’t track this data, but we can look overseas to see what’s going on with our neighbors across the pond to get an idea.

In the last three months of 2015, roughly 27% of deals fell through in the UK.  That’s nearly one in three. The top reason cited was the buyer backing out after finding something wrong with the inspection.

Take these numbers as a note of caution–deals very often fall through.  Waiving your contingencies (particularly the inspection contingency) is a good way to lose your earnest money.  

Proceed with caution when waiving any contingencies.

You ignored the timelines

In order to keep a deal moving, certain deadlines are set to protect both the buyer and seller.  As the buyer you’ll have to reach certain milestones for financing, inspection and closing within the agreed upon timeframe.

If you feel like you are not going to make one of the deadlines, let the seller know as soon as possible and ask for an extension.  As long as you are able to get extensions you’ll be ok.  Most sellers will be reasonable with you as long as you are making an effort to meet the deadlines.  

At the end of the day, they want to see the deal get done.

But, they only way to guarantee yourself protection is to just meet the deadlines.  Take them seriously and do everything you can to meet them.

You Get Second Thoughts

Unfortunately, there isn’t a “buyer’s remorse” contingency.  If you are having second thoughts about buying the property, ask yourself why.  

Is it a concern about the structure or integrity of the house?  If so, consult with your realtor.  You may have the opportunity to use one of your contingencies to back out of the deal without losing your good faith deposit.

The Seller Backs Out

There are times when the seller themselves wants to back out of the deal for whatever reason. If there hasn’t been any shortcomings on your end, you have every right to get your earnest money back.

 
Conclusion

The escrow process and putting up earnest money to buy a house can seem like a super risky gamble, but it’s really not as long as you remember to put the proper contingencies on the deal.

You’ll also want to make sure you are following the timelines set in the contract so the seller doesn’t have an excuse to keep your earnest money if the deal falls apart.

If you are in seller’s market, you might feel pressured to waive some contingencies before you are ready–never do this.  Waiving contingencies before their requirements have been met is a great way to lose your good faith deposit.

Having peace of mind and knowing you are protected is really priceless at the end of the day.