When selling your house yourself you must understand what is earnest money and why you need it. Home sellers often overlook this in For Sale By Owner transactions. That is an enormous mistake and here’s why;
Bt providing money your buyer is showing that they are serious about buying your house. So how does that work?
What is Earnest Money
You put your house on the market with sites like Zillow for all potential buyers to see. Showings are scheduled and people view your home. When one of those people makes an offer, the two of you negotiate a contract. Once you’re in contract it’s important to understand the purchase is not yet complete. They have not paid you yet but your house in now off the market. It’s not showing up as for sale anymore.
That’s why you collect earnest money at the time of contract signing.
Earnest money is a good faith deposit your buyer puts down to hold the house in contract while they go through the closing process. The closing process can comprise:
- Processing the buyers loan to get financing.
- Doing a title search to clear the title.
- The appraisal which will determine the value of the house.
- Any inspections the buyer has done.
Having money on the line keeps the buyer from changing their mind. It keeps them in contract with you.
How Much Should You Get
How much earnest money to collect is determined by several factors like where in the country you live and the price of the house.
In Wichita KS where I work the sums are relatively small. Our average is $500 to $1000 which is not much of a deterrent.
In some parts of the country like California, for instance, earnest money demands are much higher. 1-3 percent of the contract price. With an average sales price of around $580,000 that can be an excellent reason to be sure about a contract before the buyer signs. They stand the possibility of losing $10,000 or more.
Every state is different, so you’ll want to do a little research to see what they expect where you live.
Earnest money protects both you, as a For Sale By Owner, and your buyer.
You’re protected because now the buyer has skin in the game. They are less likely to walk away from the deal when they stand the chance of losing money. If they walk away, then you keep their earnest money.
There is nothing to prevent your buyer from continuing to look at homes for sale. Earnest money prevents the buyer from finding a new home and ditching your deal. If the buyer backs out for any other reason than contract contingencies, they give up the money to the seller.
Earnest money protects the buyer by showing you, the seller, that he is serious. In a multiple offer situation the amount of earnest money can be the difference between which offer is accepted.
If two offers are very similar, the one most likely to stick will have a better chance. The offer with the most earnest money at stake.
For example, if you list the house for $300,000 and one buyer is offering $500 and the other is offering $3000 the offer with $3000 at stake is more likely to close. They have more skin in the game.
What Happens With Earnest Money
Once the earnest money is collected from your buyer it’s deposited with the title company, real estate brokerage or law office. They hold the money in escrow until closing.
While not technically a deposit, they will apply the money towards the buyers down payment or closing costs.
The contract you and your buyer use will most likely have contingencies written in that concern earnest money. Those contingencies are there to protect the buyer.
When you’re looking at offers one thing you look for is a pre-approval letter from a reputable lender. This tells you your buyer can get the financing needed to buy your house. If your buyer’s financing should fall through for whatever reason it kills the real estate deal, You will then be obligated to return the earnest money and put your house back on the market.
That’s why when looking at offers financing is an important consideration. Your buyer’s financing matters.
Reasons the financing can fall through are;
- Loss of job. If your buyer loses his job, the bank will not lend the money needed to buy your house.
- Surprise medical expenses. If something serious medically happens costing a substantial amount of money, it could cause the financing to fall apart. Anything that changes the buyer’s debt to income ratio can affect their ability to get financing. Which brings me to the nest point.
- Major purchases. If your buyer goes out and buys a car, or anything that requires a loan, it could kill the deal by canceling his pre-approval. A good lender will warn the client not to make any major purchases, take out any credit, deposit or withdraw sizeable amounts of money or do anything financially out of the ordinary. You should also reiterate this to your buyer. I personally have had more than one deal fall apart because a buyer did something that affected the ability to get a loan.
Most home sales are financed so your buyer’s financing is a very important part of the real estate transaction.
A buyer has the option to preform any inspections they want to. That may include;
- A general home inspection from by a home inspection company. This is an overall visual inspection of the property. Most home inspectors aren’t experts in any particular component like plumbing, electrical, roof ect. but have a basic limited knowledge of overall home construction.
- A Radon test is a popular inspection as we know more and more about radon and its health consequences.
- My favorite inspection on older homes is a sewer scope. I have a good idea of what’s a good investment and what is not, but I can’t see the sewer. A sewer scope can see inside the sewer. Sewer repairs or replacement is a major expense, so it’s important to know that the sewer is in excellent working condition.
- Getting a roofing company to come out and inspect the roof. To have the roof replaced is another major expense. I don’t solely rely on a home inspector’s opinion about the age and condition of a roof.
What does all this mean to you? If an inspection turns up potential problems, the buyer can ask you to have those problems fixed. While it does not require you to do so the buyer may back out of the contract and get his earnest money back if you can’t come to an agreement.
Repair negotiations have a lot to do with market conditions. In a seller’s market, where there is limited supply and strong demand, you have the upper hand. In fact, in this seller’s market of the Summer of 2020 many sellers are putting their homes on the market as-is.
A preinspection prior to listing is always a good idea so you can solve these problems before you go into contract.
The appraisal is the most anxious and important part of the transaction in any market. The bank will only loan as much money as the house is worth and that’s what the appraisal determines. If you have done the work and priced your house right you should be ok.
If the house appraises for at or more than the contract price, congratulations, you’re almost to the closing table. You did a good job of pricing your house, hopefully not leaving any money on the table.
If the house doesn’t appraise you and your buyer will need to renegotiate the contract. That means either you lower the price down to the appraised value or your buyer has to make up the difference in cash. If you can’t come to an agreement, the buyer can back out of the contract and get their earnest money back.
Rarely a deal falls apart over time but that is a factor. There is a closing date on a contract and if the house doesn’t close by that date the buyer and seller must agree on an extension of the contract. If they can’t agree then the contract will expire and the earnest money will be returned to the buyer or retained by the seller depending on whose fault the delay was.
Change Of Heart
If you, as the seller, should change your mind and back out of the contract, the buyer will get their earnest money back.
Earnest money is a crucial component of the real estate transaction. While nobody wants to see a deal fall apart, having something to discourage it from happening is useful.
Selling a house by yourself without the help and expense of a real estate agent is possible and can be profitable. There’s a lot of moving parts to know and take care of. Knowing what to do is how to make it a profitable proposition.