What is Earnest Money and Why Do You Need It?
As you close in on making an offer on a home, your real estate agent – or the seller’s agent – will ask about “earnest money.” Earnest money is a type of security deposit, also known as a “good faith” deposit, offered to show the seller of a home that you’re serious about purchasing the property.
How does earnest money work?
Earnest money is the money you pay soon after a home seller has accepted your offer on a house. Earnest money assures the seller that you as the buyer are acting in good faith, and it provides them with some compensation in case you back out of the deal without a valid, contractual reason.
Once the seller’s agent is able to confirm that your earnest money has been deposited into an escrow account, the seller’s agent will mark the listing as a pending sale — in effect taking the property off the market. At this stage, various inspections, appraisals, and possibly other contingencies you had in the offer contact move forward to finalize the sale.
How much earnest money do you need to offer?
Earnest money is typically around 1% to 3% of the sale price. However, sellers are more likely to expect more earnest money in a seller’s market — where there are more buyers than homes for sale. Be sure to talk to your real estate agent about how much earnest money you should offer in the housing market you’re competing in.
Do you need to pay earnest money?
In the strictest technical terms, the answer is no – earnest money is not a requirement when you make an offer on a house. However, your offer likely won’t receive the seller’s serious consideration without putting a good faith deposit down of some kind.
Where does the earnest money go?
In most cases, your earnest money deposit is paid to the escrow or title company, which holds it in an escrow account until the transaction closes. If you work with a real estate attorney, the deposit may be put into escrow there. You can pay this deposit with a personal check, a cashier’s check from the bank, a money order, or wired funds, depending on the terms of your contract.
What does the good faith deposit count toward?
Once the sale of the home has been completed, the earnest money you paid can be applied toward your closing costs or down payment. Because the sale went through the home sellers do not get to keep the earnest money deposit.
When does the seller keep the earnest money?
If you fail to meet your offer’s contractual obligations, your earnest money could now belong to the seller. Examples include:
- After the due diligence period is over (usually a couple of weeks), you learn that the home sits in a flight path or near a refinery and you decide to walk.
- You back out for any reason not listed as a contingency in the contract.
- You cannot close on time, without a relevant contingency, and the contract has a “time is of the essence” term.
If you face any of these issues but still want to purchase the house, don’t give up. Have your agent with the seller’s real estate agent. If you are upfront about the situation, the seller may extend the timeframe. You may also want to consult with a lawyer.
When does a buyer get earnest money back?
As a buyer, you can reclaim your earnest money for a couple of reasons. First, if the seller doesn’t fulfill their side of the purchase contract. For example, if the home inspection found faulty windows and the seller agreed to replace them – but did not follow through by the contract deadline. That breach of contract allows a buyer to back out of the purchase and receive a refund of their earnest money. Second, if you have a contingency in place, and you have a reason related to that contingency to cancel the contract. There are a number of contingencies you can put into the contract and, if not met, you can walk away from the deal with your good faith deposit in hand.
Other examples of when your earnest money would commonly be refunded:
- The title company finds a lien against the property.
- Your lender denies you the loan, but you have a financing contingency in your offer.
- If your offer is contingent on selling your current home, but you are unable to do so after a given period of time.
- If you have an appraisal contingency, and the home appraises at a lower rate but the seller won’t reduce the price of the home.
Having a contingency may also allow you to negotiate the terms of your contract. For example, you may be able to ask the seller to perform repairs or give a credit at escrow to cover the agreed-upon repair costs. Typically, a buyer and seller can negotiate a resolution so the sale can be completed.
What if a buyer can’t afford a good faith deposit?
Most sellers will not consider an offer without earnest money. Keep in mind, however, that it may be possible to negotiate a work-around. If you can’t afford an upfront earnest money deposit, let the real estate agent and seller know right away. If your purchase method and financing look solid otherwise, maybe the seller will agree to move forward with the sale. If you are serious about the purchase, you may be able to ask a family member or friend to assist with a gift or loan of funds for the good faith deposit.
A word of caution: Before taking a gift, institutional loan, or getting a cash advance on a credit card for your earnest money, be sure to consult with your mortgage lender. Any new gift, bank loan or cash advance that leads to high credit card balances during your transaction timeline could be detrimental to your mortgage loan approval. This deposit is meant to secure the property, not put it at risk of losing it.
Earnest money is an integral part of most real estate transactions. Before signing a Purchase and Sale Agreement to buy a home, carefully review all contingencies, understand how much money you’ll need to pay, and know-how to successfully recover your earnest money if you need to back out of the sale.