Earnest Money: What Is It And Why Is It Important?
Sidney Richardson4-Minute Read
November 22, 2021
Buying a home, especially in a highly competitive market, can be very stressful and frustrating. If you want sellers to take your offer more seriously and help get yourself to the closing table faster, earnest money might come into play.
But what is earnest money, and is it something you always have to pay? Let’s break down what earnest money is, why it’s important and when you might use it on your home buying journey.
What Is Earnest Money When Buying A House?
Earnest money, also known as a good faith deposit, is an amount of money submitted by a prospective home buyer to show the seller how committed they are to buying the property. Earnest money is used as a type of deposit on the house you want to buy and is paid when you sign the purchase agreement.
When a buyer and seller enter into a purchase agreement, the seller must take their home off the market as the transaction moves to closing. Should the deal fall through, the seller would have to list the home all over again – which is not only inconvenient but potentially financially draining. An earnest money deposit protects the seller in case this happens – so many sellers actually require it. Even when it isn’t required, though, it can be a good idea to offer earnest money. Sellers tend to favor offers with good faith deposits because they ensure the deal will not fall apart.
The amount of money you should offer as a good faith deposit depends on the real estate transaction. In a competitive market where multiple buyers may have strong offers on a home already, you may want to offer more earnest money to make your offer look appealing to the seller. Keep in mind that there may be restrictions on the origin of the money you may wish to use as an earnest money deposit as well. For example, with a VA loan, your earnest money deposit can not have been loaned or gifted to you. If you’re unsure what a good amount to put forward is or if there might be restrictions in your situation, you may wish to consult a real estate agent or REALTOR® for help.
When is Earnest Money Refunded?
So, you pay earnest money to make your offer more appealing prior to closing – but then what? Is that money ever refunded? If your offer is accepted and you close on the loan, the earnest money you paid will likely go toward your down payment or closing costs. If the deal falls apart, however, – yes, you might get your money back.
Earnest money is generally returned to the buyer if the seller cancels the purchase contract. The amount you’ll receive back should be the same as what you initially paid as a good faith deposit. In most cases, the amount of the deposit often ranges between 1 – 3% of the purchase price, but in a competitive real estate market, sometimes earnest money might be as high as 5 – 10%.
There are a few instances where you may not get your money back. For example, if your closing went awry because you missed a deadline, you’ll likely lose your earnest money. There are ways to protect yourself from this happening, however, mainly through the use of contingencies in your purchase agreement. The following contingencies may allow you to withdraw from the sale without losing your deposit:
- Home inspection contingency. If your home is inspected and there are serious structural or repair issues, you will be able to exit the deal without penalty and regain your good faith deposit.
- Title contingency. If a title search reveals serious issues with a property’s title, you can withdraw from the sale and take back your deposit as well.
- Appraisal contingency. If your home does not appraise for the listed purchase price, you can also halt the sale and reobtain your earnest money.
A potential buyer can negotiate contingencies like these before they sign a purchase agreement to protect themselves and their money. Beyond the examples listed, there may be other ways to keep your earnest money if a deal falls through, as well as additional situations that might affect your ability to regain your earnest money, too. You should be sure to ask your real estate agent or REALTOR® if anything like this could arise during your home purchase.
Why Is An Earnest Money Deposit Important?
An earnest money deposit is valuable to both buyers and sellers. As a buyer, it shows sellers you’re serious about your offer and you have the funds to close on the home. As a seller, it protects you if the deal with the buyer falls through. Earnest money deposits are not always required when purchasing a home, but they can be very useful for all parties involved. As a buyer, a good earnest money deposit might help your offer come out on top in a bidding war.
If you’re concerned with losing your good faith deposit, should the deal fall through, consider making a contingent offer. While it can be tempting to make an offer without contingencies, especially in a competitive market where sellers might prefer it, remember that contingencies are there to protect you and can be the thing that saves you an otherwise lost deposit.
Does Earnest Money Go Towards Closing Costs?
The total amount of an earnest money deposit is usually negotiated by the buyer and seller. At closing, as we mentioned earlier, that money can be put towards the buyer’s closing costs or down payment, depending on how much was contributed. If you made an earnest money deposit of $5,000 on a home worth $175,000, for example, you could roll it into your down payment and only have to pay $12,500 rather than $17,500 if you were putting 10% down.
Regardless of what costs you put your earnest money toward, you should always make sure that when you make a good faith deposit, you have it held in an escrow account or by another third party. To protect yourself and your money, it’s always a good idea to make sure you don’t pay this deposit directly, even to your seller or lender.
The Bottom Line
Though it’s not always required, you’ll likely be making an earnest money deposit on most homes you want to purchase. Earnest money is beneficial to both buyer and seller, and as long as you make a contingent offer, you can expect to get that money back if the deal ends up falling through.
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