8 Min Read | Published: April 12, 2024
What Is Earnest Money and How Does It Work?
Explore the concept of earnest money in real estate transactions and its purpose and function in fostering trust between buyers and sellers.
At-A-Glance
Earnest money is a deposit on a home that’s used to demonstrate a buyer’s good faith in a transaction.
The amount of the earnest deposit can vary, but it’s typically between 1% to 3% of the sale price.
Earnest money is typically held in an escrow account until the deal is complete. It may or may not be refundable, depending on the terms of your contract.
When making an offer on a home, taking steps to make your offer stand out could help your bid to win. Earnest money is a tactic that some home buyers use to show how serious they are about buying a home.
While not always required, in some cases, an earnest money deposit could be a deciding factor in whether the homeowner accepts your offer. This article explores what earnest money is, how much you’ll typically need to pay, and other factors you should know before putting down earnest money.
What Is Earnest Money?
Earnest money, also known as a good faith deposit, is an amount of money a buyer pays to demonstrate their intention to proceed with a real estate transaction. Earnest money fosters trust between the potential buyer and seller, showing the buyer is committed and prepared to follow through with the purchase.
How Does Earnest Money Work?
Earnest money can be either a fixed amount or a percentage, typically between 1% and 3%, of a home’s value.1 The earnest deposit can vary, depending on what’s customary in the market that you’re in. The amount is generally lower in less competitive real estate markets and higher in more competitive markets. If you’re working with a real estate agent, they should be able to give guidance on how much earnest money to put down.
Earnest money is sometimes used as a negotiation tactic in highly competitive markets. For example, a buyer may give a larger or nonrefundable earnest deposit to make their offer more appealing to the seller. However, this strategy can be risky. If you decide to back out of the sale, you could end up forfeiting your money.
Earnest money is typically due after the seller accepts the buyer’s offer. Some ways to pay earnest money include cashier’s checks and wire transfers.2 Once the earnest deposit is collected, it’s generally held in a third-party escrow account until closing, where it could go towards your closing costs or down payment.
Earnest Money Contingencies
Earnest money may be refundable, depending on the terms of your purchase agreement.
Earnest money contingencies help protect both buyers and sellers if issues arise during a real estate transaction. These contingencies are typically written into the purchase contract, outlining the scenarios in which you may retain or potentially forfeit your earnest money.
Here are examples of common earnest money contingencies.
1. Home appraisal contingency: A home appraisal helps determine the fair market value of a home, helping buyers understand what a property is worth. Buyers could be able to walk away from a sale (with their earnest money) if the appraised value is lower than the home’s purchase price.
2. Home inspection contingency: A home inspection contingency could provide an out if the home you intend to buy requires major repairs. For example, if the inspection uncovers serious problems with the home’s foundation or electrical system, you might be able to withdraw your offer and have your earnest money returned.
3. Title contingency: You’ll want to make sure the home you intend to buy has a clean title; meaning the title has no liens or claims attached to it. A title contingency gives you the right to run a title search and walk away from the deal if issues are found.
4. Mortgage contingency: Given that most buyers need a mortgage to purchase a home, having a mortgage contingency is crucial. If you can’t secure financing to buy a home within the time frame specified in the purchase contract, you could back out and request a refund of your earnest money.
Ways to Protect Earnest Money
Here are some ways to protect your earnest money during a real estate transaction.
- Never give earnest money directly to the seller: It’s best to avoid giving the earnest deposit directly to the seller to protect both parties if there is a disagreement during the sale.
- Make the deposit to a reputable third party: You should also avoid giving your earnest money directly to a real estate brokerage. Instead, it’s safer to use a third party such as a title or escrow company, to hold your earnest money for you.
- Confirm the payment is made to the correct party: Once you send your earnest money, it’s a good idea to confirm receipt with the designated title or escrow company to verify the timely processing of your deposit.
- Include contingencies in the purchasing agreement: Contingencies, including appraisal, inspection, title and mortgage contingencies, could help protect you from uncertainty during the sale process.
- Review your contract terms: Check the terms in your purchase contract, paying attention to deadlines.
Did you know? Missing the deadlines outlined in your purchase contract may put your earnest money at risk.3
Frequently Asked Questions
The purpose of earnest money is for a potential buyer to show the seller they are serious about purchasing a property. Putting down earnest money could help strengthen your offer, especially in competitive housing markets.
If everything goes well, the earnest money will be applied directly to your down payment or closing costs. Essentially, you’re putting in the money up front.
Earnest money deposits could be refundable if the home sale falls through due to a contingency as outlined in the contract. For example, if the home failed inspection and your contract includes a home inspection contingency, you could back out of the sale and request a refund.
The Takeaway
Earnest money is a powerful way for buyers to show their commitment to a real estate transaction. Incorporating contingencies into the purchase contract, such as appraisal, mortgage and inspection contingencies, could lead to a smooth and fair process for both buyers and sellers.
1,3 “Earnest Money: What Is It And How Much Is Enough?,” Rocket
2 “What is Earnest Money in Real Estate?,” Redfin
Theresa Stevens is a personal finance writer based in Boston, Massachusetts. Her work has been featured in Forbes Advisor, Bankrate, USA TODAY Blueprint and more.
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.
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