First-time homebuyers often have questions about earnest money deposits. Here’s a breakdown of everything buyers and sellers should know about earnest money deposits and how they are used in a mortgage transaction.
What are Earnest Money Deposits?
An Earnest Money Deposit (EMD) is a check that accompanies a buyer’s offer. The purpose of an EMD is to prove that the buyer’s offer is serious and in good faith, and to provide additional “consideration” to make their offer “valid.” EMD’s tell the sellers that the buyer is serious about buying their property and that they are willing to put their money where their mouth is.
Earnest money deposits are also used to protect the sellers in case the buyer backs out of the deal at the last minute and breaks the real estate contract. EMDs are used in this scenario to compensate the seller for any “damages” resulting from the buyer who backs out of a contract without reason.
Earnest money deposit checks are made payable to an Escrow Company. EMDs usually vary in amount between $1,000 to 3% of the home’s purchase price. The EMD is applied to a buyer’s down payment and closing cost requirements at the close of escrow.
The Earnest Money Deposit Process
Earnest money deposits are customarily paid once the buyer and the seller go into contract, otherwise known as a real estate purchase agreement. Buyers offer an EMD when they submit their offer in the form of a check made payable to the selected Escrow Company handling the transaction. In many cases, there are stipulations and contingencies in the contract that would allow a buyer to back out of the purchase agreement.
Buyer Contingencies And Earnest Money Deposits
In most cases, realtors will have contingencies written into a buyer’s contract that allow them to back out of the deal if they get “cold feet.” Contingencies can be made that are reliant on the home inspection, the appraisal report, the loan approval, or several other factors.
Contingency periods can last anywhere from 5 days to 30 days. Once a buyer “removes contingencies,” they are obligated to buy the house and can no longer back out without risking losing their earnest money deposit.
“Sourceable” Earnest Money Deposits
One of the most common issues that borrowers face with earnest money deposits is making sure that they are “sourced” correctly. Lenders need a copy of the EMD check as well as a copy of the bank statement for the account from which the check is drawn.
Many realtors encourage buyers to get an EMD check from anywhere as soon as possible to “seal the deal,” but this can create larger problems down the line if not done properly.
For example, if an EMD comes from a business bank account, the entire business bank statement must be provided. The bank statement will need to have a paper trail for every large deposit. Lenders may also require a buyer’s CPA to provide letters stating that the withdrawal of the cash will not adversely impact the business, or to provide a formal cash flow analysis.
If the EMD came from a relative, lenders will need a gift letter and a bank statement from the donor. Some loan programs do not allow for gift funds, and thus the gifted EMD would be considered unusable.
If a buyer’s EMD is coming from an unusual source, it is highly recommended that they consult with their mortgage expert before submitting anything to escrow. The lender will ensure it does not affect their loan approval and qualifications.