In a competitive housing market, making an offer that will stand out from the rest is important. Prospective buyers might offer more than the asking price, put down a larger down payment and waive contingencies to make their offer more attractive. But how does earnest money factor in?
Including an earnest money deposit is one of the most effective ways to make your bid attractive to a seller. In this guide, we’ll explain what earnest money is, why it’s important and how to protect your funds.
What Is Earnest Money?
Earnest money, also known as a good faith deposit, is a sum you put down to show your commitment to buying a home. It provides the seller with protection and assurance if the buyer backs out of the purchase or cannot complete the sale.
These funds are typically held in an escrow account until closing, and buyers usually send their good faith deposit via wire transfer, a personal check or a certified check.
Is an Earnest Money Deposit Required?
No. Making an earnest money deposit is not technically required, but it has become a standard process in real estate transactions. This is especially true if you plan to purchase in a competitive housing market. If you submit an offer without an earnest money deposit, the seller can request one in a counteroffer.
The Difference Between Earnest Money and Your Down Payment
Earnest money should not be confused with a down payment, which is the initial sum paid toward the purchase of your home. Your earnest money can go toward your down payment, which is a larger sum of money, when the sale is finalized.
The Importance of Earnest Money in the Homebuying Process
Earnest money serves two primary purposes: it protects the seller and makes a buyer’s offer more attractive.
When a seller accepts your offer and you enter a purchase agreement, they take the home off the market. If you back out for some reason, the seller will have to relist the property and start the process again. This can be time-consuming and costly.
An earnest money deposit shows the seller that you are committed to going through with the sale. The seller can keep the funds if you change your mind for any reason outside of agreed-upon stipulations.
If you’re serious about moving forward with the purchase of a home, this good faith deposit effectively puts your money where your mouth is.
How Much Earnest Money Should You Offer?
Earnest money is usually about 1% to 3% of the sale price. While a larger good faith deposit can demonstrate a more significant commitment to purchase a home, other factors can influence the competitiveness of your offer.
“It can vary depending on the customs of your local market, but it all depends on what contingencies you have in place to protect that money,” says Sarah Alvarez, vice president of mortgage banking at William Raveis Mortgage. “If you have the ability to recover the entire earnest money deposit, it really shouldn’t move the needle to put additional funds down.”
Managing Earnest Money Deposits
After the buyer and seller have agreed on the terms of a home sale, the real estate purchase agreement should outline the specifics of how the buyer’s earnest money deposit will be managed. This includes where the funds will be held and any conditions where the buyer’s good faith deposit might be forfeited or refunded. The agreement could also specify deadlines and disclosures and any contingencies that must be met to finalize the deal.
Reach out to your real estate agent if you have any questions about how your earnest money is being managed.
Role of the Title Company And Escrow Account
You should never directly pay earnest money to a seller or real estate brokerage. Instead, you should utilize a title or escrow company to hold your funds.
A title company ensures a smooth transfer of ownership from the seller to the buyer during a home sale. In many cases they also provide escrow services, holding your earnest money deposit until the home sale is finalized. If a title company is not providing this service, an escrow company can also act as a neutral third party that manages these funds until the sale is complete.
The Impact of Deadlines and Contingency Clauses
Deadlines and contingencies are common in real estate purchase contracts, offering protection to both buyers and sellers. Deadlines ensure that actions like securing financing are completed on time, while contingencies allow buyers to back out if issues arise.
Deadlines that Protect the Seller
When you go under contract on a home, the purchase agreement will include deadlines to protect the seller and keep the home sale on track. These could include scheduling inspections by a certain date or securing your mortgage approval within a specific timeframe.
If you miss these deadlines, the seller could have the right to terminate the contract and keep your earnest money deposit. While most sellers understand minor delays, it’s essential to communicate quickly and address any delays that could cause the deal to fall through.
What Is a Contingency Clause?
A contingency is a clause within a real estate contract that identifies a requirement or condition that must be met to complete the sale. If a contingency is not met, one or both parties could back out of the sale. Moreover, the buyer can get their earnest money refunded if they void a contract because a contingency was not met.
In competitive housing markets, it’s not uncommon for buyers to waive certain contingencies to make an offer more attractive to the seller.
Common Contingencies in a Real Estate Contract
- Inspection contingency: An inspection contingency allows the buyer to inspect the home before closing. If the inspection uncovers any issues, this clause allows the buyer to negotiate for repairs or cancel the contract.
- Financing contingency: A financing contingency allows you to back out of the sale if you cannot secure a home loan for the property.
- Appraisal contingency: This clause allows you to back out of the sale if the home appraises for less than the agreed-upon purchase price. When an appraisal is low, you can negotiate with the seller or back out of the sale.
- Home sale contingency: You might include a home sale contingency if you need to sell your current home to buy a new one. This stipulation allows you to back out of the sale if you can not sell your current home before a specific date.
What Happens to Earnest Money if the Deal Falls Through?
It depends on the contingencies that were established in the purchase agreement. If the buyer backs out of the sale for a reason that was deemed acceptable in the contract, such as a low appraisal or issues with the home inspection, the earnest money will be refunded. If not, the seller can keep the funds.
The Most Common Way that Buyers Lose Earnest Money
Buyers that waive the financing contingency are at the most risk, according to Sarah Alvarez from William Raveis Mortgage.
“If you are not prepared to walk away from the deposit, it is very important that you protect yourself with a financing contingency in case you run into any issues with securing the mortgage,” says Alvarez. “In a busy market, many buyers are asked to waive these types of contingencies which is why it is extra important that you consult with a mortgage professional ahead of time to make sure that you are confident you will be able to achieve the necessary financing.”
Tips for Protecting Your Earnest Money
- Make Your Purchase Agreement Clear: Include the contingencies or stipulations that must be met for you to buy the home.
- Work with a Reliable Real Estate Agent or Broker: Putting earnest money down is a big deal. Having a certified expert on your side who can talk you through the process and answer any questions will make the task far less jarring.
- Ensure Proper Financing and Mortgage Preapproval: Secure your home financing and get a mortgage preapproval before making an earnest money deposit. If you submit an earnest money offer without securing a home loan, you could lose your deposit if the sale falls through.
FAQs About Earnest Money
Earnest money goes toward the down payment and closing costs after the purchase agreement is signed. These funds are usually held in an escrow account until closing.
No, earnest money is not the same as a down payment. Earnest money is a deposit that will either compensate a seller if you back out of a deal or go toward your down payment and closing costs when a contract is finalized. A down payment is a sum of money that goes directly to your lender as the initial payment on your home loan.
A seller can waive an earnest money deposit, but it’s extremely uncommon. If a buyer submits an offer without earnest money, the seller can request it in a counteroffer.
Kaitlin Davis is an experienced content writer who researches and writes about hundreds of neighborhoods across the United States. She was previously a writer for Rocket Mortgage, with a focus on mortgages, real estate and personal finance. Kaitlin earned a B.A. in print and online journalism from Wayne State University in Detroit, Michigan, where she was born and raised. Kaitlin now lives in downtown Richmond, Virginia.
