Earnest Money: What It Is And How It Works
If you’re thinking of buying a house, it’s good to know about options that might help you stand out from other hopeful buyers. Especially with the competitive market we’ve experienced recently, you want to put your best foot forward when making an offer. That’s where earnest money comes in.
What Is Earnest Money?
Earnest money is a deposit made to a home seller to show how serious you are about buying a home. This is also called a good faith deposit because the money also serves as a deposit on the property.
This is usually a deposit negotiated in the purchase agreement. A purchase agreement sets the terms and conditions of the transaction between buyer and seller. The buyer proposes the conditions of the contract, including their offer price, and the seller can agree to, reject or negotiate that contract.
Earnest Money Deposit Vs. Down Payment
Earnest money and a down payment are not the same. A down payment is the amount of money you pay upfront to the seller at closing. It’s the difference between the purchase price and your mortgage amount, which is the amount you’re borrowing. This is usually somewhere between 3% and 20% of the purchase price.
Earnest money is put into an escrow account and held there until closing. It’s then applied to your down payment. Let’s look closer at some of the details about earnest money.
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How Does Earnest Money Work?
Earnest money is indirectly given to the sellers to reinforce your commitment about moving forward in the mortgage process. A buyer makes an earnest money deposit when they and seller agree to the purchase in writing. Earnest money, or a good faith deposit, is often held in an escrow account until you close. Once you close on the home, the earnest money deposit goes toward your down payment and closing costs.
How Much Earnest Money Do I Need?
The amount you need for an earnest money deposit is either calculated by a fixed amount or percentage, depending on what market you’re in.
Fixed amount: In some markets, there’s a fixed amount that’s a standard earnest money deposit, regardless of the purchase price. This is the amount you would submit after the purchase agreement is accepted.
Percentage: In other markets, common practice is to have the earnest money tied to a certain percentage of the purchase price. For example, if the standard deposit in your area is 3%, the deposit would be $9,000 on a home with a $300,000 purchase price.
If you’re working with a real estate agent, they can tell you what you can expect to pay as an earnest money deposit in your area. To protect your earnest money, you should work with a title or escrow company instead of giving money directly to the seller or real estate firm. The funds will then be held in the escrow account until you close on the house.
Why Is Earnest Money Important In Real Estate?
While it isn’t always required, many sellers prefer an offer that includes earnest money because it shows that the buyer is serious about the purchase. If you’re looking at a house with high demand, making a larger earnest money deposit might be the thing that causes the seller to choose your offer over others.
When the seller accepts an offer, they’ll take the home off the market and expect the buyer will move forward with steps toward closing on the home, such as an appraisal and home inspection. A seller may ask for a certain percentage of the purchase price or a specific dollar amount as a deposit toward the purchase of the home. In other cases, it may depend on the housing market.
Is Earnest Money Refundable?
If you close on the house, your earnest money is applied as a credit toward your down payment and closing costs. Remember, it’s often held in an escrow account until you close. If you don’t end up closing, you can potentially end up losing your deposit. However, negotiating contingencies into the contract can protect you from losing your deposit.
Tips For Protecting Your Earnest Money Deposit
The only way to guarantee you’ll get your earnest money deposit back from escrow in the event the purchase doesn’t close, is to have a contingency in your purchase agreement. There are several types of contingencies you can use to try and protect your deposit:
- Home inspection contingency: You can write into your purchase agreement that you get your deposit back if something major comes up in the home inspection. The home inspection contingency clause protects a buyer from having to pay for major issues like a newly-purchased home needing a new roof or an HVAC system.
- Appraisal contingency: An appraisal contingency gets you your deposit back if the home doesn’t appraise for the purchase price, which is important because the lender can’t loan you more than the house is worth.
- Mortgage contingency: If you had a mortgage contingency, also called a financing contingency, included in your agreement, you can get your deposit back if your mortgage financing falls through.
- Existing home sale contingency: If you’re trying to sell your current home while buying your new one, you may negotiate to have the purchase contingent on the sale of your prior home so that you don’t have to make two mortgage payments.
It’s important to remember that some contingencies may have expiration dates that may occur before the closing date.
The Bottom Line
Earnest money is typically required, but making a larger deposit could potentially set you apart from other potential buyers. It makes the seller understand that you’re serious about buying their home. If you’re working with a real estate agent, they can give you more information about how much you should expect to deposit. And keep contingencies in mind when creating a purchase agreement, which a real will help you negotiate. Ready to take the next step in your home buying journey? Start the mortgage approval process online today.