What is earnest money and how does it work?

When you buy a home, you’re entering into a financial agreement with another person or persons. To ensure that everything is on the up and up, you put down what’s called earnest money. It’s a good faith payment that acts as collateral should you back out of buying the home for no good reason.

How much you put down in earnest money depends on the price of the home and the current real estate market. Your real estate agent can help you sort that out. Keep reading to get a more in-depth view of earnest money and what it means for you.

What is earnest money?

Earnest money acts as protection for both the buyer and seller of the home. The seller knows you’re willing to put up the money necessary (or get a mortgage) to make a final offer on the home, and if you don’t, they get to keep your money. And as long as you (the buyer) go through with the final sale, you get your money back.

In most cases, you pay 1% to 2% in earnest money. So, if you’re buying a $400,000 home, you’d pay $4,000 to $8,000. Usually, you’re not handing the cash over to the seller; rather, you deposit money via check or wire transfer into an escrow account. Your (or the seller’s) real estate agency, a title company, or a law firm controls this account so the money remains in safe hands until the deal goes through.

How much earnest money should you put down?

While 1% to 2% is the required earnest money amount by most sellers, there are times when you can put down less and times when you’ll need to put down more. This largely depends on the state of the real estate market. Always talk with your real estate agent about what they think is a fair offer.

When you’re looking for a home in competitive markets, a 1% or 2% earnest deposit isn’t competitive. To get your offer taken seriously, you may have to up that amount by a significant degree.

If the market is running slower, with houses sitting on the market for a while, offering approximately 1% is likely enough to get your offer seen. You may even tell some sellers you’re not interested in putting down an earnest deposit. Depending on how long the house has been sitting, the seller may agree.

When can you get your earnest money back?

Earnest money is purely a good faith payment. There’s no reason you should lose it unless you violate the contractual obligations you agreed to. That said, there are instances beyond your control where you must back out of the deal. The good news is you should be able to get your money back if you go about the process correctly.

Here are some instances where you’d likely get your money back:

When you close on the house

When you’re about to close on the home, there’s no use for the earnest money any longer and you’ll get it sent back to you. It’s only used if you back out of the deal with no explanation.

If an issue arises during the inspection

One of the main reasons you inspect your home is to make sure it’s in the condition the seller is claiming it is. During the inspection, if the inspector finds major damage, you can choose to back out of the sale. You may have to do this if the loan you’re taking out requires the house to be in a certain condition.

If the home appraises at a lower value than the sale price

A home appraisal is another key aspect of buying a home because it helps ensure you’re not buying a house for way more than it’s worth. If your appraiser appraises the house at a much lower value, you can negotiate. Keep in mind that the seller doesn’t need to comply. If they won’t work with you on the price, you can walk away from the deal and your earnest money goes back to you.

If the buyer is unable to get financing

One major contingency of most selling agreements is that the buyer must be able to secure the necessary funding in a reasonable amount of time. If you’re struggling to find financing after you’ve already put in an offer, you can pull out or the seller can. If this is the case, you’ll most likely get your earnest money returned.

When do you forfeit your earnest money to the seller?

While most buyers get their money back, there are a few rare instances where you’ll find yourself forfeiting your earnest money. Depending on the price of the house, this can be a sizable chunk of change.

Here are some scenarios where you might not get the money back:

If you walk away from the sale

After you’ve put down earnest money and agreed to buy the home, you often can’t back out just because you change your mind. You need to have a legitimate reason to rescind your offer, such as an inability to get financing or major damage to the home.

If you don’t complete the purchase during the necessary time frame

Real estate contracts have many contingencies you must meet for the sale to stay valid. One of those is the time frame for buying a home. Every step of the way, you’re given a time frame. You have to decide to put in an offer in a certain amount of time, you have to decide on an earnest money amount in a certain amount of time, and so on.

If you don’t stick to these time frames, you risk breaking one of these contingencies, meaning the seller can back out of the deal and you could lose your money.

How can you prevent losing your earnest money?

Luckily, losing your earnest deposit is somewhat difficult to do. As long as you stick to the time frame and have the financing you need, you should be all set. That said, here are a few actions you can take to ensure your money gets back to you:

• Understand contingencies: There is a lot written in a real estate contract, including many agreements you must stick to if you want the sale to move forward smoothly. Don’t be afraid to take the time to sit down with your real estate agent and go through every document in the contract to ensure you understand.
• Get everything in writing: If you run into issues and have no record of the transactions, you may have a hard time getting your money back. Always get every interaction in writing. It’s a good idea to send emails in addition to asking questions in person.
• Work with a reliable real estate agent: Your real estate agent is a major lifeline when buying a home. Chances are they know a whole lot more than you do about the market and your buying options, so spend some time looking for the right agent.
• Use an escrow account: Someone other than you and the seller operates the escrow account, so it makes paying your earnest money safer. They hold the money until either you or the seller needs to access it.

Earnest money FAQ

If you’re the only prospective buyer, can you skip the earnest money in your offer?

If the market is slow and a house has been on the market for a while, you may get away with not paying any earnest money. It’s up to the individual seller whether they’re comfortable proceeding without this financial safety net.

How do you pay the earnest amount to the seller?

You don’t pay the earnest money to the seller, but rather to an independent party such as a title company that keeps the money in an escrow account. Once the sale goes through, this company gives the money back to you.

What happens to the earnest money when a home purchase falls through?

If the buyer walks away from a sale for no reason, the earnest money is likely going to the seller who lost out on the sale. If there’s a legitimate reason for the sale falling through, such as a poor inspection or low appraisal, the earnest money goes back to the buyer.

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