The real estate market can be confusing to both buyers and sellers alike. During the pre-closing routine, realtors may send several documents to both parties. One of these documents deals with option fees and earnest money. Since real estate documents contain arcane language and technical jargon, you may never have even heard of these concepts. Still, it’s important to understand how the difference will affect your transaction. Here’s what you need to know about option fees vs. earnest money.
What Is an Option Fee?
Most real estate transfer contracts contain an option fee, though it’s not a legally binding requirement. An option fee is a small percentage of the total cost of a home, rarely exceeding $500. In fact, some modestly priced homes only include option fees of $100.
The purpose of an option fee is to give a prospective buyer the time to arrange safety and code inspections of the property he or she intends to buy. It serves as a right to cancel a pending transaction within a 10-day window. Since you generally pay an option fee over the table, the sellers immediately deposit the fee and rarely refund it at closing. For exceptions to these rules, your representative must codify them in the transfer contract before payment of the option fee.
What Is Earnest Money?
Earnest money, by contrast, features larger deposits that a party holds in escrow until the closing date. The value of an earnest money payment will fluctuate depending on several factors, including the state of the housing market and the purchase price of the land or home.
In general terms, you can expect an earnest money payment to exceed that of an option fee by at least a factor of 10. In extremely competitive housing markets, an earnest money deposit of 3% of the purchase price isn’t out of the question. A buyer may receive a refund for his or her earnest money payment, but this is not a legally binding requirement. A buyer, seller, and their representatives work out these issues during the drawing-up of a transfer contract.
Option Fees Vs. Earnest Money: Key Differences
The obvious, and one of the most important, difference for cash-strapped prospective buyers is size. For some prospective homebuyers, option fees may appear to be the better choice. Given all the other expenses of purchasing a home, from paying for an inspection to covering closing costs, it is tempting to save whenever possible. However, prospective home buyers (and sellers) should consider the many other differences between option fees vs. earnest money, including the following points.
Method of Deposit
A seller almost always deposits an option fee in his or her own account. An earnest money payment, by contrast, goes into an escrow account controlled by a bank or a real estate agent. While it can be virtually impossible to receive a refund for an option fee once it’s in a seller’s account, you may be able to secure a refund of your earnest money payment in slow real estate markets or in a transaction with a motivated seller.
Option fees only confer unrestricted cancellation rights during the agreed upon period, usually 10 days. On the other hand, earnest money payments may confer cancellation rights beyond this agreed upon period, such as during the following circumstances.
- The discovery of lead-based paint in a home construction prior to 1978, after a third-party inspection or legal disclosure.
- The buyer’s inability to secure financing for a purchase during the 30-day pre-closing window
- The issue of HOA (homeowners association) documents that reveal unexpected restrictions or obligations of the buyer.
Where Does the Money Go?
With an option fee, the money goes directly to the seller, generally after he or she accepts an offer on a home. Since the money goes directly into a seller’s personal account, it can be difficult to get back. An earnest money payment, on the other hand, goes into an escrow account. This means you can apply it to closing costs, a down payment, or even payment of homeowner’s insurance at the conclusion of an arrangement term.
Differences in Refund Protocols
In general, option fees are non-refundable. You should view them as a “good faith” payment to a buyer that you’re going to buy a house assuming it passes an inspection. Since they involve relatively small amounts, the non-refundable payment isn’t a deal breaker for most buyers. If you want to demand a refund to an option fee, you may choose to ask the seller to apply the amount to closing. A motivated seller might be amenable to this, but he or she is not required to do so.
Earnest money deposits, on the other hand, regularly apply to escrow. In the event that a transfer contract falls through – because of serious structural flaws or other issues with the home or property itself – you may be entitled to a full refund. Buyers who withdraw from their own accounts may be entitled to partial refunds. Your personal refund contingencies depend on the terms of your contract, so review it with your real estate agent carefully and make sure you understand its terms.
Considering the Best Method for You
Real estate options like earnest money and option fees allow a buyer an exclusive right to purchase a property. Once you “purchase the option” to buy a property, you lock in the purchase price for a predetermined length of time, and the seller cannot accept any other offers until you pass on the option, whether for structural flaws, lack of financing, or any other reason.
While option fees are the less expensive of the two options, they’re also less flexible. Option fees are non-refundable and only have cancellation rights for a pre-determined length of time. Earnest money payments are more expensive but can apply to your closing costs or give you more power during a real estate transaction.
Your choice of purchase option will depend on your unique needs, the type of property you’re trying to acquire, and your budget. Discuss the options with your real estate or title agent and understand the difference before making any purchasing decisions.