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Earnest money shows your commitment or interest in buying a home.
If sellers didn’t require earnest money deposits, they would take a risk much larger than they take accepting bids. A good faith deposit helps a seller accept your bid without worry.
Here’s how earnest money works and why it is important.
What Is Earnest Money?
Earnest money is money a buyer puts down in ‘good faith’ when bidding on a home. It shows a seller your commitment to buying the house.
Without it, anyone could bid on a home just to see if the seller accepts it and then break the contract without penalty.
An earnest deposit ensures the seller is compensated should you break the contract outside of any included contract contingencies.
Most people put down between 1% and 3% of the sales price when bidding on a home, but the exact amount varies by location and current demand.
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How Does Earnest Money Work?
When you place an offer on a property, you’ll also offer a certain amount of earnest money. If the seller accepts your offer, you’ll sign a sales contract and immediately put down the money you said you’d offer for an earnest deposit.
The money goes to a neutral third party, which is usually the title company. Here is held in an escrow account.
The money sits in the account until one of two things happen:
- You close on the home: If you close on the home, the earnest money goes toward your down payment. If you were putting down $20,000 but already put down $5,000 in earnest money, you’d need only $15,000 more at the closing.
- You back out of the contract using a contingency: If your sales contract has contingencies, you can back out of the contract and not lose your earnest money.
Contingencies could be an inspection contingency, appraisal contingency, or home sale contingency.
If the home didn’t pass an inspection, didn’t appraise for enough money, or you can’t sell your existing home in time, you can exercise your right to back out of the contract and receive your earnest money back.
You back out of the contract with no contingency
If you back out of the sales contract for any reason other than an included contingency, the seller may keep the earnest money.
The deposit compensates the seller for the time they took the home off the market.
If you don’t follow through on the contract and buy the house, the seller has to go back to square one and market the property again.
The earnest money compensates the seller for the hassle.
Earnest Money Example
John finds a home he wants to buy. He makes an offer, and the seller accepts it. In his offer, John promises a 3% earnest money deposit. Since his offer was for $250,000, John put down $7,500 in earnest money.
Two weeks into the process, John finds another home he really wants. He would like to back out of the contract on the first home, but he didn’t include any contingencies in his contract.
If John really wants to back out, he’d have to give the original seller the $7,500 he put down in earnest to compensate the seller for the time the home was off the market.
John keeps his offer and buys the original home since $7,500 is a lot of money to lose.
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What Is the Purpose of Earnest Money?
Earnest money protects sellers and keeps buyers accountable. Without earnest money, buyers could make bids on any home they see.
Sellers wouldn’t have a way of telling which buyers were serious and which were just seeing what type of offer would stick.
Earnest money keeps everything on an even playing ground. Buyers can still back out of the transaction, but they’ll know what’s at stake – a large earnest money deposit.
How Much Earnest Money Should I Put Down?
How much earnest money you should put down depends on your location, the demand in the area, and how much most people put down around you.
On average, expect to put down between 1% – 3% of the sales price. The buyer often determines the earnest money deposit amount, but some sellers have a specific amount they are comfortable with before accepting a bid.
Is Earnest Money Refundable?
Earnest money can be refundable if you have the right contingencies in your contract. Here’s when you might get your money back.
- Home Inspection Contingency: A home inspection contingency gives you time to do the home inspection and review the report. If the home inspector finds major issues with the home, you can change your mind about buying the property and get your earnest money back.
- Mortgage Contingency: A mortgage contingency protects you if you do not qualify for a mortgage. Even if you’re pre-approved, it’s a good idea to protect yourself with this contingency. What if the lender finds something they don’t like in your file? The mortgage contingency ‘buys you time’ to get your final approval without risking your earnest money.
- Appraisal Contingency: An appraisal contingencyprotects your investment in a home if the appraised value isn’t high enough. Some sellers let bids get higher than the home’s fair market value. Most lenders won’t allow financing on a home when a buyer will pay more than the home’s value. Since you won’t know a home’s fair market value until after the home appraisal, an appraisal contingency protects your earnest money. If the house isn’t worth as much as you offered, you can cancel the sale and get your money back.
- Home Sale Contingency: If you have a home to sell, a home sale contingency protects you if you can’t sell your home in time to have the funds to close on your purchase. Simultaneously buying and selling a home can be tricky, and the home sale contingency gives you until a certain date to sell your home or back out of the contract, keeping your earnest money.
- Clear Title Contingency: A clear title contingency allows the title company time to search the chain of title and look for any unresolved liens or homeownership issues. It’s not a common contingency, but if you have reason to worry about the chain of title, it can be a good contingency to add to your contract.
What Happens to Earnest Money When a Deal Falls Through?
If a deal falls through, one party is keeping the earnest money – but who?
It depends on the situation. Without a contingency on the contract, the seller keeps the earnest money as compensation for taking the home off the market.
If there is a contingency, aka a valid reason for backing out of the contract, you may keep your earnest money, but only if all contingency conditions are met.
The neutral third party (usually the title company) decides where the earnest money goes.
When Can the Seller Keep My Earnest Money Deposit?
The seller can keep your earnest money if you back out of a contract for any reason except those noted in a real estate contingency.
If you don’t have any contingencies and you back out of the contract – the seller keeps your earnest money.
Earnest Money Pros and Cons
Pros:
- A higher earnest money deposit may help you win in a bidding war
- Earnest money shows your seriousness about buying the home
- Earnest money enables you to make well thought out decisions versus spontaneously bidding on a home you may not want
Cons:
- You could lose your deposit if you have to back out of the contract
- Another buyer can outbid you with a higher earnest money deposit
- Only contingencies on a contract protect your money, but sellers don’t like contingencies
What is the Difference Between Earnest Money and a Down Payment?
Earnest money is used to show your commitment to buying the home. You can put it toward your down payment or closing costs.
You can also receive it back in your possession if you paid for your down payment another way or have a no down payment loan.
A down payment is capital you invest in the home – paying the seller directly versus borrowing the money from a bank to buy the house.
Banks control your down payment, but title companies or escrow companies control your good faith deposit.
What Happens to Earnest Money After Closing?
Once you close, the money comes back to you, or the closing agent can deduct the amount off the amount of cash you need to close.
Your cash to close comes from your down payment and closing costs.
For example, if you put down $10,000 and your closing costs are $10,000, you’d need $20,000.
If you put down $5,000 in earnest money, the title company can take the $5,000 and apply it to your $20,000 total.
How Can Earnest Money be Protected?
To protect your earnest money, get everything in writing, starting with the sales contract. In the sales contract, work out any contingencies you think would help protect your earnest money.
For example, if you have a house to sell, consider the home sale contingency or if you’re worried about the inspection, use the inspection contingency.
Only use a reputable title or escrow company to hold your earnest money deposit and make sure the terms are clearly written out, so there aren’t any arguments or miscommunications regarding who has the right to the money.
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What Happens If I Can’t Afford Earnest Money?
Your earnest money deposit is a part of your down payment, but if you weren’t planning on making a down payment, you may not be able to afford an earnest money deposit.
Ask your lender if you can borrow funds from family or friends and still get approved for financing. If not, ask your real estate agent to waive the earnest money requirement.
Unless you’re in a competitive market, the seller may be willing, especially if they recognize your desire to buy the house.
Bottom Line: What Is Earnest Money?
Earnest money is a typical part of buying a home. It feels like you’re paying the seller early, but the seller doesn’t get the money. It’s a deposit that protects both you and the seller during escrow.
Once you close, the money goes toward the purchase, decreasing the amount of cash you need to close. If you don’t close, though, it goes to the seller.
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