What is earnest money and how does it work?
March 9, 2023 4 min read
Want to buy a home? It’s helpful to know how upfront expenses—like the down payment and closing costs—could affect your home buying budget. You’ll probably want to factor earnest money into that budget too.
Even though earnest money deposits aren’t required by law, they’re a standard practice in real estate transactions. But what exactly is earnest money? Who pays it? And how does it work?
- A buyer makes an earnest money deposit to demonstrate their intent to purchase a home.
- The deposit amount is typically 1% to 2% of the purchase price.
- Earnest money may be held in an escrow account until the sale is finalized.
- Including contingencies in the purchase agreement could help protect earnest money deposits.
What is earnest money in real estate?
Earnest money is a good faith deposit made by a buyer to a seller. It’s commonly used in real estate transactions to show that a buyer is serious about purchasing a home.
Once the seller accepts the buyer’s offer, a purchase agreement is signed. Buyers typically pay an earnest money deposit within one or two days of their offer being accepted. The money may be held by a third party—sometimes in an escrow account—until the sale is finalized.
Keep in mind that earnest money deposits and down payments are two separate expenses. Buyers with mortgages pay a down payment, which is a portion of the home’s purchase price, at closing. The down payment amount is typically set by the lender and can vary depending on the type of home loan.
How much earnest money is required?
Earnest money deposits may range from 1% to 2% of the home’s price. But in a seller’s market, buyers may offer higher deposits to give themselves a competitive edge.
Who holds earnest money?
Earnest money is typically held by a third party in an escrow account. The money remains in the account while both parties complete the terms of the contract. At closing, the funds are returned to the buyer and are often applied to the down payment or closing costs.
Is earnest money refundable?
In some instances, earnest money may be refunded. But it depends on the terms of the purchase agreement.
Ways to protect earnest money deposits
There are steps buyers and sellers could take to help protect these deposits, such as:
- Carefully reviewing the terms of the contract.
- Ensuring the contract is signed by both parties.
- Working with an experienced real estate agent.
- Confirming the payment is made to the correct party.
- Including contingencies in the purchase agreement.
Be aware that earnest money shouldn’t be sent directly to the seller. Instead, buyers could make the deposit payable to a reputable third party—like an escrow agent, law firm or brokerage—for safekeeping. They should also keep a receipt of the payment for their records.
Contingencies and earnest money
From financing to appraisals to inspections, real estate transactions have many moving parts. But what happens to earnest money if a home sale doesn’t go according to plan?
That’s where contingencies come into play. A contingency is a clause that states that a specific requirement must be met for a sale to be finalized. If the buyer or seller doesn’t uphold the contingent terms, the other party may be able to back out of the deal and keep the earnest money deposit.
Here are some common contingencies found in real estate agreements:
Home appraisal contingency
A mortgage is a secured loan with the financed home typically serving as collateral. Before lenders approve a mortgage, or refinance an existing one, they may require a home appraisal. The appraisal can help a lender determine whether it’s financing a home for more than it’s worth.
Having an appraisal contingency can also ensure that the buyer doesn’t pay more for a home than its current market value.
Home inspection contingency
A home inspection can help save buyers from unexpected repair costs. Buyers can request a home inspection contingency, which gives them time to hire an inspector and have the property evaluated.
Inspectors can check for undisclosed issues, such as faulty electrical wiring, water damage and more. If any problems are uncovered, the buyer may ask the seller to fix them. If the seller isn’t willing to handle the repairs or cover the costs, the buyer could back out of the deal and recover their deposit.
Before a buyer signs on the dotted line, they’ll want to make sure the home’s title is clean. But what does that mean exactly?
A clean, or clear, title is one that doesn’t have outstanding liens, judgements or other legal issues. It’s common for a buyer’s attorney or a title company to conduct a title search and check for these types of disputes. A title contingency could help protect buyers in the event that the search uncovers an issue.
Home sale contingency
Buyers may need to sell their current home to afford another one. A home sale contingency could give buyers time to sell their home before closing on a new property.
Buyers often need a mortgage to purchase a home. A mortgage contingency may give buyers a specific time frame in which to secure financing for the purchase. If they’re unable to do so, they can back out of the deal and keep the deposit. The seller can then put their house back on the market.
Earnest money in a nutshell
When a seller accepts a buyer’s offer, both parties sign a purchase agreement. The buyer then makes a good faith deposit, known as earnest money, to show their intent to purchase the home.
Earnest money isn’t required by law, but it’s a standard real estate practice. The deposit is typically 1% to 2% of the purchase price, and the funds are held by a third party until the contract terms are completed. But if one party doesn’t fulfill the agreement, earnest money might be refundable.
If you’re a prospective homebuyer, it’s helpful to factor expenses like earnest money, closing costs and home inspections into your home buying budget. Having a dedicated savings account could help you track your progress.
Want to learn more? You could review these important questions to ask when buying a home.