What Is Earnest Money?
There are a few ways that today’s homebuyers can stand out in a competitive market, such as getting a preapproval from a lender (or a Preliminary Preapproval, which uses a soft credit pull rather than a hard credit inquiry) and offering a strong “earnest money deposit.”
This article answers your pressing earnest money questions, including:
- What is earnest money?
- How much should homebuyers pay in earnest money (and to whom)?
- Is earnest money refundable?
- How can homebuyers protect their earnest money deposits?
What Is Earnest Money?
Earnest money definition: Earnest money is a deposit that homebuyers use to demonstrate their commitment to purchasing a house from a property seller[1]. This deposit is intended to assure the seller that the buyer is acting in good faith, which is why it is sometimes called a good faith deposit. Buyers and sellers can agree to use the earnest money toward either the down payment or closing costs.
Why Is Earnest Money Important?
Earnest money is an important part of the buying process because it assures sellers that a buyer is serious about their intent to purchase.
In many cases, when a seller accepts an offer to purchase their home, they remove the listing from the market while the buyer has the home inspected, has the property appraised, and secures any financing they need to complete the purchase. If the deal falls through, the seller has lost valuable time on the market, during which they could have potentially found another buyer.
The earnest money deposit is intended to minimize frivolous offers from parties without serious intention to complete the purchase.
How Much Earnest Money Should a Homebuyer Pay?
Earnest money amounts vary widely, depending on factors like current local market conditions and expected demand for the individual property. For example, in a strong seller's market, you may want to offer a higher earnest money deposit to make the offer more appealing than any competing offers. But for a fixer-upper with low demand in a slower market, you may be able to offer less. The amount could be a percentage of the offer price, or it could be a flat rate.
If you are working with a real estate professional, they should be able to provide guidance on how much your earnest money should be to be competitive in your local market. In many markets, buyers can expect to put down 1% to 3% of the purchase price as earnest money.
This amount may be paid to a designated third party, like a real estate brokerage, escrow company, title company or law firm. It is not recommended to pay the deposit directly to the seller.
Is Earnest Money Refundable?
Earnest money may be refundable. Many home-purchase contracts list contingencies, which are conditions that must be met for the deal to close. If one of the contingencies listed in the purchase contract cannot be met and the deal cannot close, the buyer may be entitled to a refund of the earnest money.
For example, if a purchase contract contains a home inspection contingency and a financing contingency, the buyer may be able to have their deposit refunded if the home inspection is not satisfactory or the financing needed to complete the purchase cannot be obtained[2].
When Does the Buyer Lose Their Earnest Money?
Buyers may lose their earnest deposit if they back out of a deal for any reason not listed as a contingency in the purchase contract[1]. It is important to note that other factors, like waiving your contingencies or ignoring deadlines built within the purchase contract, can result in the forfeiture of a good faith deposit. Keep reading to learn about ways to protect your earnest money deposit.
What If I Change My Mind as a Buyer?
Changing your mind for reasons unrelated to the contingencies listed in the purchase contract may be viewed as a failure to act in good faith, which could result in the loss of the earnest money deposit. This forfeiture would help to compensate the seller for the time, money, and effort needed to re-list the property and search for another buyer.
How to Protect Your Earnest Money Deposit
Here are four ways to protect your earnest money:
- Pay the earnest money deposit to a reputable third-party (rather than paying the seller directly). This minimizes the risk of losing the deposit if you must cancel the purchase contract due to an unmet contingency.
- Think carefully before waiving contingencies. In a hot market, buyers may waive contingencies to make their offer more appealing to sellers by removing as many hurdles to closing as possible. However, removing contingencies limits the buyer’s rights to back out of a deal due to a problem with the property or financing. This puts the earnest money at greater risk of being lost.
- Pay attention to any deadlines listed in the contract. To keep the deal on schedule, the contract may list specific dates by which contingencies must be met. For example, the contract may stipulate that the buyer must have the home inspected within seven days. Failing to meet such deadlines could be considered a lack of good faith and may result in the forfeiture of the earnest money.
- Pay close attention to your purchase agreement and understand everything that is in writing. The purchase agreement is a binding contract between you and the seller and will detail your responsibilities.
More Earnest Money FAQs
Here are more commonly asked questions about earnest money deposits.
What Is the Purpose of Earnest Money?
The purchase of earnest money demonstrates a buyer’s serious intention to purchase a specific home by backing the purchase offer with cash. This increases the stakes for the buyer and can prevent buyers from making frivolous offers to purchase properties.
Does Earnest Money Really Matter?
Earnest money can make a difference to sellers who are taking a risk by taking their property off the market due to a signed purchase contract. If the deal falls through, the sellers may return to square one of the selling process. So, when given a choice between two identical purchase offers, sellers might accept the offer with the higher earnest money.
Is Earnest Money the Same as a Down Payment?
Earnest money is not the same as a down payment, which is the amount of the purchase price the seller is paying out of pocket (as opposed to financing with a mortgage loan). However, the earnest money may be applied toward the down payment if the deal closes as expected.
What Is an Example of Earnest Money?
Sellers need to sell their homes quickly, so they price them competitively. Knowing there could be multiple offers for this property, a buyer offers slightly more than the asking price and offers a higher-than-standard earnest money deposit to incentivize the seller to accept their offer. The seller accepts the buyer’s offer, and the deal proceeds as expected. At closing, the earnest money is applied toward the down payment.
Who Keeps Earnest Money If the Deal Falls Through?
If the deal falls through, the earnest money may be distributed to either the buyer or the seller, depending on the circumstances, in accordance with the purchase contract.
If the buyer backs out of a deal because a contingency cannot be met (for example, there is an appraisal contingency, and the property appraises for less than the offer price), the buyer may be entitled to a refund of the deposit.
If, on the other hand, the buyer backs out because they changed their mind for a reason unrelated to any contingencies in the contract, the seller may be entitled to the earnest money as compensation for having the property off the market during the contract period.
How Does Earnest Money Relate to a Home Loan?
Buyers can include a financing contingency in their purchase contract, potentially allowing them to back out of a deal, and have their earnest money refunded, if financing cannot be secured.
However, serious buyers would rather obtain the required financing to close the deal than back out and have to start their home search from the beginning. This is why many homebuyers choose to get pre-approved for a home loan early in the home search process.
Buying a home is a big investment, and the earnest money you pay upfront shows the sellers how committed you are to the transaction.
