Do I really need to have earnest money?

As summer 2021 is in full swing, the housing market is tightening. Homebuyers are facing a bit more competition as they look to bid on their perfect home. Perhaps you, as a homebuyer, have been in the unfortunate position of being outbid on a home you really wanted. That is where earnest money can come in handy and can give you the advantage over other bidders on the home you want.

What is earnest money?

Earnest money is rather simple in concept. It is a deposit homebuyers pay to home sellers once the buyer’s offer has been accepted. It is a way buyers let sellers know they are serious about making the purchase. While having a significant down payment lets lenders know a buyer is serious about purchasing, earnest money serves in a similar role for sellers.

Generally, buyers need to come up with anywhere between 1% and 5% of the home’s purchase price as earnest money if they are serious about bidding on a home. Such money acts as protection for sellers in the event that the contract cannot be finalized because of some type of condition of sale was not met, or circumstances arose that weren’t covered by a contingency. The seller can then use the money to list their property again, or for other expenses.

When buyers make an offer on a home, the offer or contract will state how much earnest money the potential buyer will put down. The money will not go directly to the seller, but instead will be held in an escrow account through an entity the seller hires such as an attorney or a title company.

Once the sale is finalized and closed, the earnest money is applied to the buyer’s closing costs, down payment or even toward a mortgage payment. The contract will state where the earnest money is applied. However it is applied, earnest money eventually becomes equity in the home a borrower purchases. While earnest money may not be required in all cases, sellers may decide not to entertain any offers without it. That is especially true in tight housing markets.

Sellers may try to bypass an escrow account and ask to have the earnest money paid directly to them. That is not recommended because an escrow account provides protection to both parties. As stated earlier, it protects the seller in case the buyer isn’t able to close on the home and the buyer must relist the property. Earnest money in an escrow account protects the potential buyer in the event that the seller is withholding information about the home that could make the potential buyer balk at making the purchase.

Earnest money and hot housing markets

Earnest money is a terrific way for buyers to show sellers they want to purchase. But it can also be an important negotiating tactic when the housing market is competitive.

For instance, a borrower finds a home on the market after getting pre-approved for a mortgage (see our blog on the topic of Mortgage Pre-Qualification Vs Pre-Approval). And that home is in perfect condition and has all the amenities the buyer is looking for. That borrower suspects that the home is going to get a slew of offers. While some who bid on that home may only offer 1% of the purchase price, other potential buyers can gain an advantage by offering more.

Ultimately, it is an excellent idea for homebuyers to budget in earnest money when they begin their search for a new home. It may not be absolutely necessary, but homebuyers are better prepared if they have it budgeted in their finances.

If you are in the market for a new home or even just considering it, we are here to help. Call us at 888-400-1373 or email [email protected] and one of our experienced loan originators will be happy to answer whatever questions you have.