So a buyer has found the perfect house and wants to make an offer. Typically a seller or the listing agent requires an earnest money deposit. So what is an earnest money deposit (EMD)? It is basically good faith money. This deposit is given by the buyer to an escrow officer who holds the funds. This starts the purchase or escrow process. The escrow officer could be the closing attorney or the real estate company. Here are the basic steps in the EMD process.
Earnest Money Deposit Steps
- Prepare purchase contract (the offer)
- Include earnest money amount in contract
- Contract acceptance
- Buyer provides EMD check
- EMD deposited into trust account
- If purchase closes:
- Buyer is given credit for deposit. It reduces amount required at closing
- If purchase does not close:
- Funds are disbursed per contract
Earnest Money Deposit Warnings
Since earnest money funds may be documented during the mortgage process, avoid certain mistakes. First of all, never pay a deposit in cash. Because cash is very difficult to prove the source. Basically it could be from anyone. Also if the contract deposit comes from someone other than the buyer, tell the lender first. When funds are paid by another, it could at least cause a gift documentation requirement. What if the relative won’t provide the gift documentation? So Realtors should pay attention to the earnest money deposit given. If cash or a check not in the buyers name, question it. Also never give earnest money directly to the seller! There is nothing wrong with a for sale by owner transaction but don’t give your deposit to the seller. It would be better to give it to the closing attorney or escrow company. If the deal goes south, a buyer would not want their deposit in the hands of the other party!
Earnest Money Deposit vs Down Payment
Again, EMD is initial good faith funds given by the buyer. Although down payment is given at closing, not all purchases require down payment. Additionally, not all sellers require earnest money. At closing, the earnest money may be credited towards funds for closing. Basically the EMD is given as a credit at closing towards the buyer’s required funds. Let’s use the following example to show how down payment and EMD works
Purchase price = $200,000
Down payment = $40,000
Closing costs = $4,000
Loan amount = $160,000
EMD = $1,000
In this example, the buyer would have paid $1000 at execution of the purchase contract. Based on above, $44,000 is due at closing minus the $1,000 already paid up front. Down payment plus closing costs minus already paid EMD equals $43,000 remainder due at closing.
How to Document EMD funds
In order to use earnest money at closing, the buyer often needs to show evidence they have enough assets. Whether EMD must be documented depends on several factors. First the loan type determines how and if funds must be verified. Another factor involves down payment requirement. For instance if an FHA loan and the EMD is part of the down payment, it must be proven per HUD guidelines.
Lender Earnest Money Requirements
Lenders use bank statements to prove the buyer has sufficient funds to pay the earnest money. So the most recent bank statement is reviewed to ensure the borrower had enough money to pay the EMD and funds at closing. As a buyer, always make sure the check is written from an account with sufficient funds in it. Plus an important tip is not to ever deposit cash into accounts prior to or during the mortgage process. Check out our article “Avoid cash when purchasing a home and applying for a mortgage!“. It is good advice to save issues during the mortgage process! Sometimes on a VA loan that requires no money to close, the Veteran can just provide the EMD cancelled check.
Earnest Money Deposit Refund
As mentioned above, there are times when a down payment is not even required. If a buyer uses a VA, USDA, or down payment assistance loan, a down payment may not be required. Additionally the seller may pay all or most of the closing costs. So in these cases, there could be a refund of earnest money. In these cases, proving the earnest money definitely is an advantage to the buyer.
One last piece of advice is to make sure the earnest money is deposited up-front. Otherwise it could cause issues in proving it cleared (in case it is required). So better to be safe and deposit the funds once received into the escrow or trust account. If there are any questions before accepting the EMD, ask us. We would rather that it is done correctly the first time.