Is Earnest Money Part of Closing Costs?
Clarify the relationship between earnest money deposits and closing costs in your home buying process.
Purchasing a home involves navigating various financial considerations, each playing a distinct role in the transaction. Understanding these components is crucial for prospective homeowners as they prepare for one of life’s most significant investments. Earnest money and closing costs are distinct financial concepts, but their interplay is often a point of confusion for buyers. This article aims to clarify the nature of each and how they ultimately affect the home buying process.
What Earnest Money Is
Earnest money is a deposit made by a buyer to a seller, demonstrating a serious intent to purchase a property. This “good faith” deposit signals to the seller that the buyer is committed to the transaction and will follow through with the purchase, assuming all contractual conditions are met.
The amount of earnest money is typically negotiated between the buyer and seller, often ranging from 1% to 3% of the home’s purchase price, though it can be higher in competitive markets. This deposit is held in a neutral third-party escrow account, usually managed by a title company, real estate brokerage, or attorney. The funds remain in this account until the sale closes or the contract is terminated.
Earnest money can be returned to the buyer under specific conditions, which are usually outlined as contingencies in the purchase agreement. Common contingencies include the home inspection revealing significant issues, the appraisal value coming in below the agreed-upon price, or the buyer being unable to secure financing. If the buyer backs out for reasons not covered by these contingencies, or fails to meet contractual deadlines, the earnest money may be forfeited to the seller as compensation for taking the property off the market.
What Closing Costs Are
Closing costs are the various fees and expenses incurred by both buyers and sellers during the finalization of a real estate transaction. These costs are associated with the transfer of property ownership and the securing of a mortgage. They encompass a wide range of services and legal requirements necessary to complete the sale.
Examples of common closing costs for buyers include loan origination fees, which lenders charge for processing the loan application, typically ranging from 0.5% to 1% of the loan amount. Appraisal fees, usually between $300 and $750, cover the cost of a licensed appraiser determining the home’s value. Buyers also typically pay for title insurance, which protects against defects in the property’s title, with costs often between 0.1% and 1% of the purchase price.
Additional closing costs can involve attorney fees, recording fees for officially registering the new ownership, and transfer taxes. Buyers may also pre-pay for property taxes and homeowner’s insurance premiums. These costs can vary significantly based on location and the specifics of the transaction, and they can be paid by either the buyer or seller, or split between them, depending on the terms of the purchase agreement.
How Earnest Money Affects Closing
Earnest money is generally not an additional cost added to closing expenses. Instead, it functions as a credit that is applied towards the buyer’s financial obligations at the time of closing. This means the earnest money reduces the total amount of cash a buyer needs to bring to the closing table.
When the sale proceeds as planned, the earnest money deposit is typically credited towards the buyer’s down payment. For instance, if a buyer makes a $5,000 earnest money deposit and needs a $20,000 down payment, they would then only need to bring an additional $15,000 for the down payment at closing. Any remaining earnest money after the down payment is satisfied can then be applied towards other closing costs, such as loan origination fees or title insurance premiums.
This application is clearly reflected on the closing disclosure document, where the earnest money appears as a credit to the buyer. The earnest money acts as a pre-payment or a partial payment, ensuring the buyer’s commitment while also contributing directly to the funds required for the purchase. If the earnest money exceeds the total amount due for the down payment and closing costs, the buyer would receive a refund for the excess amount.