Earnest money in real estate is like a deposit for a property. It’s different than a down payment. You may wonder, “Is earnest money refundable?” or “Who keeps earnest money if a deal falls through?” We’ll answer this and other questions about an earnest money deposit in this article.
What Is an Earnest Money Deposit in Real Estate?
Earnest money is money that a buyer gives a seller to show they are serious about purchasing a property. It is essentially a deposit on a home and may also be called “good faith money.”
Earnest money protects the interests of both the seller and the buyer.
It shows the seller that the buyer is serious about buying the home. This is reassuring to the seller and may encourage them to take their home off the market while awaiting the next steps of the negotiation process.
In addition, a considerable earnest money deposit may make a buyer’s offer more compelling to the seller, especially if multiple offers exist. A buyer with a higher earnest money deposit may also get more favorable contract terms.
Related Article: Handling and Negotiating Multiple Offers
How Does Earnest Money Work?
When a buyer decides to purchase a property, the buyer and seller enter into a contract. The contract ensures the seller takes the house off the market while it’s appraised and inspected. The buyer makes an earnest money deposit to prove they won’t withdraw the offer without a specific reason that is written into the contract. After all, if they do, the buyer will lose their earnest money.
Earnest money is usually delivered when the sales contract or purchase agreement is signed. However, earnest money can also be attached to the offer.
It’s important to note that earnest money funds aren’t given directly to the seller. Instead, they are typically held in an escrow account until closing. (An escrow account is overseen by a third party. The funds are placed there temporarily until a particular condition has been met.)
The earnest money deposit can be applied to the buyer’s down payment or closing costs when the sale goes through. The buyer doesn’t get to keep these additional funds on top of the purchase amount of the property.
Related Article: What Is Closing in Real Estate? What to Expect During the Closing Process
The buyer might be able to reclaim the earnest money if something that was specified in the contract goes wrong. For instance, the earnest money may be returned to the buyer if the house doesn’t appraise for the sales price or the inspection reveals a serious problem. However, it’s important to note that these “contingencies” must be written into the counteract.
Related Article: What Does Contingent Mean in Real Estate?
It’s important to note that if there are multiple offers on the property, some buyers may increase their deposit amount to make their offer more attractive. During bidding wars, a buyer may not include contingencies in their contract. This shows the seller that they are extremely serious about making the deal go through.
How Much Earnest Money Should a Homebuyer Pay?
The local market dictates how much earnest money a homebuyer should pay the seller. Typically, the amount ranges between 1% and 2% of the home’s purchase price. However, in hot housing markets, the earnest money deposit might range between 5% and 10% of the sale price. Still, some buyers offer a fixed amount.
A seller may also require additional earnest deposits if the appraisals or inspections take a long time.
How to Protect Your Earnest Money Deposit
Here’s how buyers can protect their earnest money deposit.
1. Use a trusted escrow account
Never give earnest money directly to the seller. Earnest money is typically deposited into an escrow account overseen by a third party. The funds remain in the account until closing when they are typically applied to the buyer’s down payment or closing costs.
2. Understand the terms of the contract
Buyers must understand the terms of their contract with the seller. For example, some contracts can be written with the contingency that the earnest money will be returned if the financing doesn’t go through. If the buyer waves this contingency, and something goes wrong with the mortgage, the buyer will lose their earnest money.
3. Meet all deadlines
Home purchase contracts often have time limits. Failure to close the transaction on the agreed-upon date means you have breached the contract, and the buyer may have to forfeit their earnest money.
4. Document everything
When submitting earnest money, the contract terms must be explicit. A buyer might consider having a real estate attorney review each document before signing.
5. Request a receipt
In addition to asking for a receipt, buyers must be careful when paying earnest money. Cybercriminals may send emails or texts to buyers with a last-minute account change for their earnest money or deposit. Buyers and their agents must verify accounts before depositing money.
Is Earnest Money Refundable?
Earnest money is sometimes refundable. It depends on how the contract is written and if deadlines are met.
For example, suppose a contract is contingent on the home inspection, and the inspection reveals material issues with the property. In that case, the buyer can usually choose to renegotiate or back out of the purchase with their earnest money.
If the contract is contingent on the appraisal and the property appraises for less than the agreed purchase price, the buyer can renegotiate or withdraw from the deal with their earnest money.
A buyer may also have their earnest money refunded if their current home doesn’t sell or they can’t get financing – as long as those contingencies are written into the contract.
Alternatively, the seller gets to keep the earnest money if the buyer decides not to go through with the purchase for reasons not specified in the contract. For example, if a buyer has a change of heart and decides not to buy the property, the seller is most likely able to keep the earnest money.
Earnest Money vs Down Payment
Earnest money and money for a down payment serve different purposes.
- Earnest money shows a seller that a buyer is serious about their offer for a property. On the other hand, a mortgage company requires a down payment from a buyer to secure financing for the purchase of the property.
- Earnest money is often one or two percent of the purchase price—or a flat amount—and is placed in an escrow account. However, the down payment is often 10 to 20% of the purchase price, depending on the type of mortgage, the lender’s requirements, and the buyer’s financial situation. The down payment reduces the amount of money that needs to be borrowed.
Please note that earnest money submitted by buyers can be applied to the down payment amount during a successful transaction.
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Key Takeaways
- Earnest money is a deposit the buyer makes to show their commitment to purchasing a property. It’s typically 1-2% of the home’s purchase price and is held in an escrow account until the transaction is completed.
- Earnest money protects both the buyer and the seller. If the buyer backs out of the purchase without a valid reason specified in the contract, the seller may keep the earnest money. However, the buyer may reclaim their deposit if the contract includes contingencies, such as a failed inspection or appraisal.
- Earnest money is different from a down payment. While earnest money demonstrates the buyer’s seriousness, the lender requires a down payment to secure financing for the home purchase. Earnest money can be applied to the down payment upon closing.
- Buyers should protect their earnest money by using a trusted escrow account, understanding contract terms, meeting deadlines, and documenting everything. This helps ensure the deposit is handled correctly and returned if necessary.
