We’ll explain what earnest money is, why it’s important, how you can use it to your advantage when buying a home, and how to protect your deposit if things go wrong and you don’t end up closing.
What Is Earnest Money?
Earnest money is a deposit that is made by buyers when a contract for sale or purchase agreement is signed. It is typically due when the contract is signed, but earnest money can also accompany an initial offer. The earnest money deposit demonstrates a potential buyer’s seriousness and protects the seller in the event the buyer backs out of the deal without just cause.
An example of how depositing earnest money makes transactions more likely to close is the fact that it discourages buyers from shopping around or making offers on other homes once they’ve already signed a purchase agreement.
It’s also common to see realtors use EMD as an abbreviation for earnest money deposit, while some may even refer to it as a good faith deposit.
How Does Earnest Money Work?
Once a purchase agreement is signed between the buyer and seller, it’s expected that the seller will take the home off the market. It can take some time for a closing to go through, as there’s a due diligence process for the buyer that includes inspecting the home, and of course, there’s the matter of financing and finalizing a mortgage. In return for taking the house off the market, most sellers expect buyers to provide an earnest money deposit to be held in escrow. The earnest money deposit will be held in escrow by a third party, typically a real estate brokerage, your attorney, or a title or escrow company. If everything goes smoothly, the earnest money deposit is applied to the closing costs or the buyer’s down payment.
If financing doesn’t come through or a bad home inspection results in the deal falling through, the buyer can get their money back, assuming that appropriate contingencies were listed in the purchase agreement (we’ll take a more in-depth look at contingencies and if earnest money is refundable in a bit).
How Much Is An Earnest Money Deposit?
As a general rule, the earnest money deposit is typically somewhere between 1% - 5% of the purchase price. The exact amount depends on your market, and can at times, be as high as 10%. Assuming you’re working with a real estate agent, they’ll be able to advise you on what’s appropriate for the local market. In a booming real estate market, you might put down more earnest money, while in a slow market, you might not need to put more than 1% down.
Is Earnest Money Refundable?
Earnest money is generally refundable, and how and why will be outlined in the contract. The earnest money contract should contain contingencies that protect both the seller and buyer, the most common of which are financing and home inspection contingencies. Basically, if even though you’ve made an offer that the seller has accepted, the sale will only be finalized once all contingencies listed in the purchase agreement are met.
Earnest Money Contract & Contingencies
For both parties to protect themselves, the earnest money contract should contain various contingencies, or requirements, that need to be met for the sale to close. Below you’ll find information on the most common contingencies.
If you’re going to be getting a mortgage, you’ll want a financing contingency. Even if you’re preapproved, it’s possible for financing to fall through, and the last thing you’ll want is to lose your earnest money deposit if that happens, making this contingency very important.
Home Inspection Contingency
Another common concern for many buyers is having the home inspected. Nobody wants to buy a home only to find out they’ll need to invest tens of thousands of dollars into a new roof or fixing cracks in the foundation. A home inspection contingency can provide buyers protection and a way to back out of a deal if the property has a bad home inspection report. With this contingency, you can get your earnest money back after an unsatisfactory home inspection.
Other Common Contingencies
Various other conditions or contingencies can be put into the contract, the most common of which is an appraisal contingency. With an appraisal contingency, the buyer can back out of the deal if the home appraises for less than the sales price. Another common contingency is one for selling your existing home. Buyers should make sure they cover all their bases with the appropriate contingencies to ensure that they can receive an earnest money refund if things don’t go according to plan, and they’re unable to close on the house.
Protecting Your Earnest Money Deposit
If you’re buying a property, there are a number of ways to protect your earnest money deposit. Here’s what you’ll want to do:
- Use contingencies- You should always include contingencies for financing and inspections. Without these, your earnest deposit could be forfeited if things go awry.
- Use escrow- It’s imperative to make sure the deposit is held in escrow by a reputable third party. Do not give the deposit directly to the seller. You’ll also want to obtain a receipt for the earnest money.
- Stay on top of everything- You’ll want to make sure you stay on top of everything and always abide by the terms of your contract. For example, if inspections need to happen by a specific date, don’t mess around and risk missing the deadline and jeopardizing your deposit.
While earnest money may seem like another inconvenient cost you need to cover during the buying process, it’s actually extremely vital as it shows the seller you’re a serious and motivated buyer. The earnest money deposit gives sellers peace of mind, knowing you won’t back out of a purchase contract if you simply change your mind.