HomebuyingEverything You Need To Know About Earnest Money

Everything You Need To Know About Earnest Money

Earnest money is one of the ways you can secure a home, especially in a competitive market like we’re in today. Unfortunately, not a lot of people talk about earnest money, and so many buyers are unprepared for this part of the process.

In this guide, we’ll discuss what you need to know about earnest money, how it works, and what you should expect if you need to pay earnest money while you’re buying a home.

What Is Earnest Money?

The simplest definition is that earnest money is something a buyer pays to the seller when buying a house. It’s a deposit the buyer makes to the seller to prove that they’re serious about buying the property. You might also hear people refer to earnest money as “good faith money,” “escrow deposit,” or just a deposit on a home. All it means is that the deposit is paid to show that you’re determined to buy a home and to protect you and the seller from last-minute changes to the contract or failure to follow through.

The exact amount of the earnest money may depend on the cost of the home, how competitive the housing market is in your area, and how well you and your realtor negotiate.

Earnest money is usually less than the deposit on your home and may even be less than the closing costs. It’s not designed to be a large expense, just one that provides a little more security for the buyer and seller.

Is Earnest Money Required to Get a Home?

Earnest money is a key part of the homebuying process, but it’s not strictly required. The seller decides whether they want to ask for earnest money and may decide they don’t need it in some cases. However, most of the time, a home seller will ask for earnest money.

Since earnest money is at the seller’s discretion, the amount can also vary. It’s typically between 1-3% of the total purchase price, but it may be slightly less or more depending on each transaction.

You can also offer a larger percentage payment for earnest money to make your offer more appealing to the seller or as a way to negotiate better contract terms. In other words, if you have a little extra cash available to add to the earnest money, you might be able to get a more favorable contract and close more quickly.

Does Earnest Money Count Toward the Down Payment?

Earnest money can be an interesting part of getting a mortgage because the exact terms of the earnest money depend on what you and the seller negotiate. That means that sometimes the earnest money may not count toward any of the other expenses of the home.

More often, though, the earnest money is applied to one of the major costs of buying your home. It’s common to apply the earnest money to the down payment, but you can also use it as a deposit on the closing costs. Whichever option you prefer, you’ll need to negotiate the terms with the seller.

Can Earnest Money Be Refunded If the Sale Doesn’t Go Through?

Contrary to popular belief, the earnest money isn’t always lost if your home contract doesn’t go through. When you sign the purchase agreement, it’s crucial to look at the terms. The specifics about your earnest money are defined in the contract, and the more detailed they are, the better off you’ll be.

There isn’t a guarantee that you won’t lose your earnest money. We’ll discuss some of the reasons you might lose it in the next section, but here are some reasons you might be able to get your money back if you decide not to move forward.

For instance, if you run into a common real estate deal-breaker, you generally will be able to get a refund on the earnest money paid. Here are some situations where you could get your money back.

Home Inspection Contingency: Home Inspection Has Problems

Most of the time, a home inspection is a formality designed to ensure there aren’t any serious problems that aren’t easily visible or any safety problems. If your home inspection comes back with serious issues, you may be able to walk away from the deal and get your earnest money back.

Home Financing Contingency: Buyer’s Loan Falls Through

Most prepared buyers understand the importance of getting pre-approved. However, a mortgage pre-approval doesn’t guarantee financing. A mortgage pre-approval is without much due diligence, and in some other cases, problems arise during the actual underwriting process, which could lead to the bank refusing a mortgage. When financing falls through, the buyer can often get their earnest money returned, even though they are the ones backing out of the sale.

Home Sale Contingency: Buyer’s Previous Home Doesn’t Sell

In some cases, a buyer will start looking for a home to purchase while at the same time trying to sell their existing home. In most cases, it’d be ideal to sell the home first and use the equity as the down payment for the new home. It can, however, make financing difficult if the buyer isn’t able to sell the current home before they close on their new house. You can usually get the earnest money back if you have a home sale contingency in place.

Home Appraisal Contingency: Home Value Lower Than Expected

The last common refund situation happens when the home is appraised much lower than anticipated. This is also known as an “appraisal shortfall.” Lenders are likely not going to extend you a loan if the home you’re looking to purchase is appraised below the agreed purchase price. An appraisal shortfall indicates to the lender that the property subject to the sale is not worth that much and thus limits the maximum amount of financing they’d be willing to provide. Of course, there are ways to solve a low appraisal, including negotiating with the seller to lower the purchase price. But suppose the seller is unwilling to negotiate, and you don’t have additional cash to bridge the difference. In that case, you will be able to get the earnest money back if your contract includes a home appraisal contingency.

Reasons You May Lose Your Earnest Money

Just like there are some situations where your earnest money can be refunded, there are some cases where the house seller will keep your earnest money, even if you don’t purchase the home. There are really only two situations where this is likely.

You Waive Your Contingencies

The contingencies are written into your agreement to protect your right to have the money returned if the inspection or appraisal doesn’t go well. You can waive those contingencies in exchange for a better deal, but that also means that you won’t be able to get your earnest money back if something does go wrong.

You Exceed the Contract Timeline

When you’re buying a home, your contract usually includes deadlines for when certain parts of the transaction must be completed. On average, it takes around 30 to 45 days to close on a home. If you fail to close within the timeline, the seller may back out of the sale without returning your earnest money. Usually, the exact details for failure to meet the timeline are also outlined in the contract.

Who Is Earnest Money Paid To?

Earnest money is rarely paid directly to the seller. Instead, the earnest money typically goes to an escrow account managed by a real estate broker, legal firm, or title company. Putting the earnest money or deposit in an escrow account helps protect the buyer during the closing process.

How You Can Protect Your Earnest Money

Since earnest money can be a significant amount and may impact your home budget if you have a sale fall through without a refund, it’s important to take steps to protect your earnest money.

Here are some basic things you can do to make sure your earnest money is as safe as possible.

  • Understand your contingencies: knowing the exact provisions of your contract will tell you when you can get your earnest money back and when you can’t.
  • Use an escrow account and make sure the funds are properly handled: putting the money in an escrow account gives both you and the seller confidence that your contract will be honored.
  • Meet your obligations: Knowing what you’ve agreed to do and when you’ve agreed to do it is the next important part of ensuring your earnest money is safe. Following your contract obligations closely will help.