What Is Earnest Money and How Much Should You Pay?

What Is Earnest Money and How Much Should You Pay?

While buying or selling your house, you will encounter numerous real estate jargon you have never heard about. One such term you will hear during the home buying process is earnest money deposit. So, what is an earnest money deposit?

Earnest money for house, otherwise known as the good faith deposit, is the amount of money the buyer initially pays to the seller, indicating the seriousness of purchasing the house. In simple terms, when you find your dream house and enter into a purchase agreement with the seller, the homeowner will withdraw the property from the real estate market.

To seal the deal, the homebuyer deposits to show the seller an intention to proceed with the home purchase. Typically, these deposits are mostly held in a real estate escrow account till the deal closes.

If you haven’t set aside a certain amount in your budget for the earnest money deposit, this expenditure might come as a surprise while purchasing the house. To avoid such things from happening, we provide an overview of everything you need to know about earnest money in real estate while purchasing your house.

What Is Earnest Money In Real Estate? Earnest Money Definition

Earnest money is an initial deposit made in good faith to show you’re serious when signing a real estate purchase agreement. Once the buyer enters into an agreement with the seller, the house is taken off the market as a transaction proceeds to closing. If the deal falls through, the purchase process returns to square one. The seller will have to relist the property and start the entire process again, causing a huge financial setback.

Mostly, earnest money is a deposit on the house you are planning to buy. The amount is transferred while signing the real estate sales contract or purchase agreement. Sometimes, real estate earnest money payment is considered part of the purchase offer.

While signing the contract, the homeowner and buyer outlines the conditions of how to refund the earnest money if the deal doesn’t go through. To define earnest money amount, who holds it, and how quickly it has to be submitted, you must go through the contract carefully.

To submit the earnest money deposit, it is advisable to hire a reputable third party and get a receipt to protect yourself in case of any default. Besides, you may also end up losing the earnest money deposit if you do not adhere to the terms and conditions stipulated in the purchase contract.

Typical Earnest Money Means

Earnest money deposits protect the interests of the sleeker if the buyer backs out from the agreement. The typical earnest money amount ranges between 1 – 5% of the property’s total purchase price. There’s no specific requirement concerning how much the earnest money deposit must be. The amount varies based on the state you reside in and the local real estate market conditions.

The earnest funds are generally kept in an escrow account until the sales deal is complete. If the deal goes smoothly without hiccups, the earnest payment is added to the buyer’s closing costs and down payment.

If the buyer backs out from the deal due to failed house inspection or any other contingencies mentioned in the agreement, the buyer is entitled to refund the earnest money. Depositing a certain amount initially and entering into an earnest money contract reduces the chances of prospective buyers placing offers on multiple properties, eventually backing out once the seller takes the property off the market.

How Does Earnest Money Work?

The amount you must deposit as good faith deposit depends on various factors such as:

  • The current real estate market condition.
  • Policies and limitations exist in your state.
  • Recommendations of your real estate agent.
  • The amount specified by the seller.

If you’re purchasing a home in a market where properties do not sell off quickly, the seller might require only less than 1% as a good faith deposit. When the demand is high, sellers often ask for higher earnest money deposits, at times as high as 3% to 4%.

How Does Earnest Money Work?

In some cases, the real estate agents might advise you to pay a larger deposit to the seller to win the bid. If you’re making a larger earnest money deposit, your seller might even be willing to negotiate the purchase price. To make larger deposits, you must verify your source of funds and do lots of paperwork to get loan approval from your mortgage lender or the bank.

However, it is best not to put down too much amount as an earnest money deposit. Instead, you can put the money to good use rather than keeping it stagnant for months till the sales agreement closes.

Who Holds The Earnest Money Deposit?

Once you accept the offer and sign the purchase agreement, in most cases, the contract stipulates that you must make an earnest money deposit to the title company. In certain states, the buyer’s real estate agent or a real estate broker handles this deposit amount to safeguard the interest of both parties involved in the contract.

Before making a good faith deposit, always check the credentials of the real estate broker or the title company that holds your deposit. It would be best to verify whether the funds are held in an escrow account. Avoid giving the earnest money deposit directly to the seller. If something goes wrong and the seller scams you, it won’t be easy to get back your deposit.

After signing the earnest money check, if funds are cashed, it’s held in an escrow account till the purchase offer reaches the final stage. Once the sales deal goes through, the funds are automatically released from the escrow account and applied to the down payment and closing costs.

The seller can retain the earnest money deposit if the prospective buyer falls out of the deal. This is why sellers need to carefully review the purchase agreement to see if they can take any legal action for the financial loss they incurred. In case the buyer backs out due to any reason mentioned in the contract, they are legally entitled to get the good faith deposit refunded.

How Much Earnest Money Should You Pay?

The amount of earnest money deposit you must pay varies based on various factors. Usually, you’ll have to deposit 1% to 5% of the total purchase price. If you’re looking for a house in a prime location with great cash offers and bidding wars, you will have to pay a lot of earnest money for the house.

For highly competitive properties having numerous potential buyers, the deposit amount can go as high as 10%. A lower earnest money deposit would work great if the property is in a slow market. In some cases, sellers prefer to fix a certain amount as a deposit in the earnest money agreement to filter out the buyers who are not serious about purchasing the property.

Are you still wondering how much is earnest money deposit? In order to find out the reasonable earnest money amount for the property, it is best to connect with an experienced local real estate agent. These agents will inspect the entire property and assess the market-specific factors to quote a certain figure as an earnest money deposit within the standard market range.

Is It Necessary To Pay Earnest Money? 

As per law, an earnest money deposit is not always required in a real estate purchase agreement. But, entering into an earnest money agreement is a standard practice that most sellers demand before accepting a sales contract to avoid financial hits if the buyer backs out. Also, making this initial payment can be necessary if you’re looking for a house in the competitive real estate market.

Besides, this good faith deposit acts as added insurance for both parties involved in the contract. The deposited amount signals the homeowner to indicate how serious you are about the home purchase offer. If the buyer backs out for any reason not mentioned in the agreement, the seller holds the right to keep the deposits.

Another benefit is that earnest money helps reduce the amount you need to pay while closing the deal, as it’s directly applied to your down payment or closing expenses. In simple terms, it’s the money you’re paying in advance during the initial steps of the purchasing process.

Is Earnest Money Part Of Down Payment?

Now that we have understood what earnest money is, let’s clarify this. The good faith deposit you made to the seller as a promise to purchase a house is not considered a down payment. Down payment is completely different from the initial deposit you make. It is the upfront amount you pay to secure the financing of the property you bought.

The down payment would generally be around 10 to 20% of your home’s purchase price with a fixed-rate 15-year mortgage loan. In other words, earnest money deposits help secure the purchase offer, and the down payment amount secures your mortgage financing.

So, while calculating how much money you will have to pay to purchase a house, you can include the earnest money into the budget you create for closing costs. You must pay the good faith deposit when you accept and sign the purchase offer. Meanwhile, the down payment and closing cost can be paid later when you close the deal on the property.

Earnest Money Vs Down Payment: Explained 

More often, earnest money and down payment is confusing. Though both are closely related, these payments are not the same. Earnest money deposit is the amount you pay the seller to assure you will purchase the property, which is later included in the down payment when the deal closes.

Earnest Money Down Payment
Acts as a promise to the seller. Is a promise to the lender who provides a home loan.
Financial commitment indicating buyer’s seriousness to buy the property. Cash payment the buyer provides to purchase the house.
Typical amount varies from 1% to 5% of the total purchase price. Typically ranges from 3% to 20% or above, based on the loan type.

Is Earnest Money Refundable?

Earnest money deposits must be returned to the buyer if something goes wrong during the appraisal. However, the conditions must be predetermined in the purchase agreement. Also, the buyer gets the earnest money deposit back if the seller terminates the contract without any valid reason.

Keep in mind the good faith money deposits will not be returned to the buyer under certain conditions, which include:

  1. The flaw was not stipulated in the contract. Or
  2. If the buyer decides to back out from the agreement before closing the deal.

Conditions for earnest money refunds

The buyer’s real estate agent’s responsibility is to ensure that the contract has the right type of contingencies included to get back the earnest money deposits in case of any default. Some of the deal breakers mentioned in a contract when it comes to real estate earnest money deposits are:

  • The house does not pass the inspection test. Instead, it reveals serious structural damages or needs remodeling and repairs, and you’re not able to reach an agreement with the seller concerning the renovation works.
  • When the home buyer faces hiccups in procuring the mortgage from the lender or is not able to secure the required financing.
  • When the seller is not willing to renegotiate the sales price, even when the house is not appraised at the sales offer amount. Or when the appraisal amount is much lower than the property’s selling price.
  • The buyer is not able to sell off their current property before closing the deal on the new one.
  • A title search of the property reveals there are problems with the title ownership.
  • Not paying attention to the deadlines mentioned in the contract.

Earnest Money: Final Thoughts 

Purchasing a house is a huge investment, or you need to make the best offer and ensure that you remain protected throughout the process. Earnest money deposit assures the seller about the buyer’s commitment to purchase the property, allowing you to stand out from the other potential buyers. Also, this good faith deposit protects the buyer if there’s something wrong with the property.

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