What is Earnest Money?

Homebuying can be competitive. Just when you think you’ve found your dream home, another buyer swoops in to take it away. It happens, and that’s why buyers often look for ways to stand out to sellers. That’s where earnest money deposits can come in.  

In this article, we will explain what earnest money is and how it works in real estate transactions. By the end, you will be equipped with an understanding of this potentially useful tool in your homebuying toolkit.

Explaining Earnest Money in Real Estate

Earnest money is a type of deposit that buyers can put down as a show of good faith with the seller when negotiating a purchase agreement. It is not always required, but it can make a big difference in competitive markets. It’s an upfront deposit, typically placed in an escrow account, that can be put toward closing costs and the down payment if the sale goes through.  

Once an earnest money deposit is made, the seller will usually take the home off the market while the buyer initiates a home inspection and appraisal. So, this deposit more or less serves two main purposes:  

1. Show the seller that you are serious about the purchase. 
2. Protect the seller in the event that you back out of the deal for any reason outside of the contingencies in your purchase agreement.  

Sellers take a risk when they pull their homes off the market after a purchase agreement. If your deal falls through, they will have to relist their home and start their process all over again. This can cost them money and a lot of time.

Is Earnest Money Refundable?

Earnest money deposits can be refundable under certain circumstances. Generally, in a purchase agreement, buyers will negotiate contingencies with the seller for the purchase. These contingencies can protect the buyer from losing their deposit if they back out for an agreed upon reason.  

Otherwise, the earnest money deposit will either be:  

• Distributed from the escrow account toward the down payment and closing costs upon loan closing.  

• Distributed to the seller if the buyer backed out for any reason other than those outlined in the purchase agreement. 

Common Contingencies for a Home Purchase

Contingencies vary from purchase to purchase. However, there are some common ones to consider negotiating into your purchase agreement, as they can both help you recoup your earnest money when backing out for specific reasons and give you peace of mind on other aspects of this major financial decision. Here are a few contingencies to think about: 

1. Home Inspection: It is not uncommon that a home inspection will uncover serious problems in a home, and those problems may be too difficult for a buyer to move forward with the purchase. This contingency ensures that after a licensed professional inspects the home, you are able to back out and get your earnest money, should they find certain problems. Otherwise, you may be able to negotiate repairs with the seller.  
2. Appraisal: The appraisal contingency is generally used to protect buyers in the event that the appraised value is lower than the agreed upon sale price. It can let buyers leave the deal with their earnest money, or it can give them an opportunity to negotiate a new price with the seller. 
3. Mortgage/Financing: If the buyer is unable to secure a mortgage for the purchase, the mortgage, or financing, contingency lets them back out and, if agreed upon, take back their earnest money. 
4. Existing Home Sale: This contingency is often put in place to ensure the buyer can sell their home before having to move forward with the purchase. 

How Much Earnest Money Should I Pay?

The amount of earnest money the buyer should pay depends on a lot of different factors. A good real estate agent can often help you figure out what kind of earnest money offer would be appropriate for the home you’re targeting.  

One of the main factors at play is the competitiveness of the market. If you’re buying in a sellers’ market, you may need to put down more earnest money to help you stand out from other buyers.  

Depending on the norms in your area, you may end up paying a fixed amount or a percentage of the purchase price of the home. Often, that percentage is between 1% to 3%, but it can be higher or lower based on the competitiveness of the market and other factors in your purchase agreement negotiations.  

Also, not that as mentioned before, these funds are usually placed in an escrow account, rather than given directly to the seller. The reason for this is to protect buyers from fraud.

Final Thoughts

Earnest money, while not always necessary, can be a useful tool to stand out in competitive real estate markets. Those deposits help sellers know that you are a serious buyer, and they protect the seller in the event that you must pull out of the purchase agreement for reasons not negotiated in your contract. If you are getting ready to buy a home, it can be good to work with a real estate agent for guidance on how to handle your earnest money deposit.