What is an earnest money deposit?
The basics of earnest money deposits
- Many sellers require earnest money as part of the purchase agreement.
- Buyers put down earnest money to show the seriousness of an offer.
- The deposit is typically 1 to 3 percent of the purchase price.
- The money is held in escrow until the deal closes, then it goes toward the buyer’s down payment.
A promise and a handshake are sometimes all that’s needed to make a deal. When it comes to purchasing a home, however, a more significant gesture of intention is required. The earnest money deposit serves this function.
Also known as a good faith deposit, an earnest money deposit is an amount of money put forward by a potential homebuyer to demonstrate the seriousness of their purchase offer. It is not an additional cost — if the deal is completed, the earnest money deposit is applied toward the buyer’s down payment.
Why earnest money?
Buying a home is not a snap transaction. When a seller accepts a buyer’s purchase offer, they take their home off the market while the closing process gets underway. If a buyer is not serious in their intention to purchase and later deserts the deal, the seller has lost precious time and money.
To avoid receiving multiple haphazard offers, sellers may require that an earnest money deposit be made. Not only does an earnest money deposit inform the seller of the buyer’s seriousness in purchasing the home, it can be a bargaining item in hot real estate markets to make a purchase offer stand out above other buyers.
How much is paid?
It is a common misconception that states dictate how much money should be paid as an earnest money deposit. While most sellers require earnest money with a purchase offer, the amount required is between the two parties.
Typically, an earnest money deposit is 1 to 3 percent of the home purchase price, though it can also be a fixed amount. In a buyer’s market, the amount may be significantly less or waived altogether. In a seller’s market, the sky is the limit. The more money a potential buyer puts forward, the more it incentivizes the seller to ensure the deal closes successfully.
It is usually best to offer a percentage in line with the average earnest money deposit in your area. A real estate agent can advise you. Too high of a deposit and the buyer risks losing a lot of money if forced to step away from the deal; too low, and the buyer risks offending the seller or leading them to believe the purchase offer is not serious.
How it works
Once a seller accepts a buyer’s offer on their home, a purchase contract is signed. This marks the beginning of the closing process. The earnest money is then transferred into an escrow account, typically managed either by the title company or a real estate broker.
While the earnest money deposit protects the seller from the risk of a failed deal, putting the funds into escrow protects the buyer should the seller back out of the transaction. The money is held in this third-party account until both parties agree on the terms of the sale, typically after all contingencies are evaluated.
In an ideal situation, the buyer gets the home and the earnest money deposit is released to the seller as part of the down payment. This is not always the case, however.
The purchase contract outlines the conditions under which the earnest money deposit can be repaid. In most cases, the deposit can be refunded to the buyer if the seller decides to abandon the deal, or in the event that the home does not meet certain contingencies outlined in the contract — the discovery of a major flaw during the home inspection, for example.
There are scenarios in which the seller can keep the earnest money deposit as well. If the buyer simply changes their mind, it is usually within a seller’s rights to retain the money. Depending on the contract, a seller may be able to keep the earnest money deposit if the buyer’s financing falls through.
If the sale falls through, a cancellation fee is charged by the company holding the escrow, regardless of which party initiated the cancelation. It is essential for both buyers and sellers to understand all contingencies in their contract and how the earnest money deposit will be handled, before signing the purchase agreement.