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 point of making an earnest money deposit is to demonstrate a potential buyer’s seriousness and protect the seller in the event the buyer backs out of the deal without just cause.
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.
- Earnest Money Deposit
- Due Diligence
1. Earnest Money Deposit
The earnest money deposit is made when the purchase agreement is signed. This is because once a purchase agreement is signed between the buyer and seller, it’s expected that the seller will take the home off the market. 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.
2. Due Diligence
After making an earnest money deposit, the buyer will begin the due diligence process. It can take some time for a closing to go through, as the buyer's due diligence can include numerous steps, including inspecting the home. If all goes well with the inspections and appraisals during the due diligence period, the mortgage loan will be finalized so that the sale can go through.
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 the earnest money deposit is refundable in a bit).
An earnest money deposit is typically between 1% to 5% of the purchase price. That being said, 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.
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.
The earnest money deposit is extremely vital as it shows the seller you’re a serious and motivated buyer. It gives sellers peace of mind, knowing you won’t back out of a purchase contract if you simply change your mind.
One key example of why depositing earnest money is important is that it 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.
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.
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.
- Financing Contingency
- Home Inspection Contingency
- Other Common Contingencies
1. Financing Contingency
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.
2. 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.
3. 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.
The earnest money deposit is important as it shows the seller you're serious about buying the home. As a buyer, you should be ready to pay earnest money once you sign the contract, but it's important to use escrow so that you're protected in case the deal falls apart. By putting the earnest deposit in an escrow account you're certain to be refunded in the event the seller backs out or the deal goes sour.