Earnest Money: What Is It And How It Works

Buying a house may require an upfront deposit, meaning buyers need funds immediately after a seller accepts their offer. The deposit is called an earnest money deposit. The deposit could mean the difference between a seller accepting or declining an offer.

What Is Earnest Money?

Earnest money, also known as a good faith deposit, is an upfront deposit you offer when making an offer on a house. This deposit, often between 1% – 3% of the purchase price, demonstrates your commitment to buying a house. It shows the seller you’re serious about the home and have no intention of backing out of the offer.

Earnest money is often used to entice a seller to accept a particular offer. It’s even more common during a seller’s market when buyers are looking for ways to make their offers stand out. In many places, it’s a requirement of getting an offer accepted, regardless of the type of housing market you are in.

How Does Earnest Money Work?

Though earnest money is part of your offer when buying a home, it doesn’t technically go directly to the seller. Instead, once you and the seller enter into a contract, the agreed-upon earnest money goes into an escrow account, where it’s held until the deal closes or falls through. Once the earnest money is paid, the seller takes the home off the market.

If the sale goes through, the earnest money is released from escrow on the closing day and counts toward your down payment. However, if you back out of the sale, the seller may be able to keep the earnest money.

For example, suppose you make an offer on a home and put down 2% earnest money. However, the inspection shows the home has some serious damage. The seller isn’t willing to renegotiate the contract, you can’t afford to make them yourself and the contract doesn’t include an inspection contingency. If you back out of the sale, the seller gets to keep the 2% earnest money.

Every purchase agreement is different, and yours may specify how earnest money will be handled in certain situations.

How Much Earnest Money Should You Offer?

In most cases, earnest money is between 1% – 3% of a home purchase price. For example, earnest money on a home priced at $300,000 may cost between $3,000 – $9,000.

The amount you offer within that range is up to you (and the housing market). If your current housing market favors sellers, your real estate agent may advise you to make a larger earnest money deposit to make your offer stand out more. On the other hand, in a buyer’s market, you may be able to get away with a smaller earnest money deposit.

The Pros And Cons Of Earnest Money

Though earnest money may seem like another upfront expense to be paid, it has some important benefits for you as a buyer. Of course, there are also a few downsides.

Pros

• Demonstrates your intention to close on the house: Earnest money helps to show that you both want to buy their house and have the financial ability to do so.
• Contributes to your down payment or closing costs: Earnest money isn’t another added cost of home buying. Instead, it counts toward your down payment and/or closing costs when you close on the home.
• Helps you compete in a seller’s market: In a seller’s market, it’s important to find any way to stand out. Earnest money, especially a large deposit, can help your offer stand out from the crowd.

Cons

• Can be lost if the buyer backs out: Unfortunately, you’re likely to lose your earnest money if you back out of the sale, leaving you less money to buy a home.
• Prevents you from making multiple offers simultaneously: Offering earnest money can help your offer stand out from the crowd but can make shopping around difficult since you can’t commit the same money to multiple sellers.
• Difficulty getting the money back: You may have a difficult time getting the money back if the deal falls through, even if it’s due to something outside of your control, such as the inspection or appraisal results.

4 Ways To Protect Your Earnest Money

As we’ve mentioned, a buyer can lose their earnest money if they back out of a home sale. However, there are a few steps you can take to protect your money.

1.  Include Contingencies

When you’re making an offer on a home, you probably want to include some purchase contingencies. A contingency is a clause in your purchase agreement that allows you to back out of the sale without penalty in certain situations.

Some of the most common contingencies are:

• Financing: A financing contingency allows you to back out of the sale and recover your earnest money if you don’t qualify for financing. Though this situation isn’t likely, especially if you’ve been preapproved, it is possible.
• Home inspection: A home inspection contingency allows you to back out of a home sale based on the results of the home inspection. Though these contingencies can be written in different ways, one might allow you to back out if the needed repairs exceed a certain dollar amount.
• Home appraisal: A home appraisal contingency allows you to back out of a home sale if the home appraises for lower than the agreed-upon purchase price. For example, your purchase agreement may allow you to back out if the home appraises for at least $5,000 lower than the purchase price.
• Home sale: A home sale contingency allows you to back out of a home sale if you aren’t able to sell your current home. This type of contingency is common for buyers who are selling their current home while buying another.

If the sale falls through because of a contingency, you can recover your earnest money – though it’s important to include language in the purchase agreement that makes that clear.

2.  Ensure That All Details Are Documented

One of the best ways to protect yourself is to have everything related to your earnest money as well documented as possible. Your purchase agreement should clearly outline everything, from where the money will be held to what situations allow you to recover it.

When you’re talking about thousands of dollars, the last thing you want is any vagueness or lack of clarity in your purchase agreement that could leave room for debate about who gets to keep the earnest money if the deal falls through.

3.  Pay Attention To Contingency Deadlines

A purchase agreement often includes deadlines for certain contingencies. For example, it wouldn’t necessarily be fair to invoke the inspection contingency long after your offer is accepted and just before you’re scheduled to close on the home.

A purchase agreement is likely to include a specific contingency period for each contingency. For example, an inspection contingency might last just 2 weeks, meaning you have 2 weeks from the time the purchase agreement is signed to have an inspection and decide whether to move forward with the sale.

The financing contingency often has the longest deadline. Your purchase agreement may give you as much as 30 or 60 days to invoke the financing contingency.

4.  Use An Escrow Account

When you make an earnest money deposit, you don’t write a check to hand directly to the seller. Instead, you should use an escrow account to hold the money until the sale closes or falls through. The escrow account should be managed by a neutral third party to ensure that neither the buyer nor the seller can access it. When the money is deposited into the escrow account, you should receive documentation, including a receipt of the deposit.

Earnest Money FAQs

Earnest money can be an important part of the home buying process, and it’s important to understand how it works. Here are some additional frequently asked questions about earnest money and how it affects buyers.

Is earnest money refundable?

Earnest money is refundable in certain situations. First, if the sale goes through, your earnest money applies toward your down payment and/or closing costs. If the sale falls through, you can get your earnest money back if your purchase agreement has certain contingencies and the sale falls through because of one of them.

What’s the difference between earnest money and a down payment?

Earnest money is a good faith deposit to make your offer more attractive to the seller, while a down payment is required to qualify for a loan. The earnest money, though it requires payment upfront, isn’t actually a cost of buying a home. Instead, it applies toward your down payment and/or closing costs when the sale closes.

Is earnest money required?

Earnest money isn’t required to buy a home, but your real estate agent may strongly recommend it. Earnest money is more common during a seller’s market since buyers need a way to make their offers stand out. If the current housing market favors buyers, earnest money may be less important, but still very common.

How is earnest money paid?

Earnest money can generally be paid using a personal check, cashier’s check or wire deposit. Rather than paying the earnest money deposit directly to the seller, you’ll pay it to a third-party escrow company, which will hold the money until the sale is complete.

What happens to earnest money when you close on a house?

When you close on your home, the earnest money you paid will be applied toward your down payment and/or closing costs. The benefit is that it reduces the amount you’ll have to pay on the closing day.

The Bottom Line

An earnest money deposit is standard practice in the real estate industry. It allows buyers to make their offers stand out in a competitive market. It shows a seller that you’re a serious buyer and assures them that you have no intention of backing out of the sale.

If you’re planning to buy a home soon, it’s important to start getting your finances in order ahead of time, and that includes getting preapproved for a loan to find out how much you can borrow. Start the mortgage approval process today to get one step closer to buying your home.