Homebuyers

What Is Earnest Money and How Does It Work?

The number of homes on the market may be on the rise, but the lack of homes for sale still trails what would be considered a “healthy” housing market. That’s why homebuyers may need to take advantage of every opportunity to make their offers stand out.

For some buyers, that could include getting pre-approved for a loan, waiving contingencies, or it could include putting down an earnest money deposit.

Separate from the down payment, earnest money is a small “good faith” deposit buyers can put down to show the seller they are serious about purchasing their home. It’s usually thousands of dollars. 

“Offering money can increase the appeal of your proposal as it demonstrates your commitment to proceed with the transaction smoothly,” said Brett Johnson, a real estate agent and owner of New Era Home Buyers in Englewood, Colo. 

However, buyers shouldn’t make an earnest money deposit unless they are confident the deal will go through. There are situations in which the money may not be refundable.

Let’s take a look at earnest money, when it makes sense, and how to protect yourself from losing it. 

What is earnest money?

Earnest money is typically submitted at the same time as the offer on the home before the closing. It’s often used as an incentive to push an offer to the top of the seller’s “yes” pile. 

It can also help to create trust in the transaction, said Erwin Miciano, a real estate investor and owner of Semi Homes in Los Angeles, Calif. 

“It’s a signal to the seller that the buyer is committed,” Miciano said. “Without it, sellers might wonder if the buyer could walk away at any moment. I’ve seen deals fall apart over smaller issues, so that extra financial skin in the game helps keep both parties moving forward.”

While it’s not necessary or required, an earnest money deposit is a “customary gesture that demonstrates your genuine interest,” Johnson said.

How much should you offer in earnest money?

The average amount of earnest money deposit ranges from 1% to 3% of the purchase price.

That amount can vary depending on a number of factors, including the state of the housing market. If it’s a seller’s market, buyers may want to put down more. If it’s a buyer’s market, the reverse may be true.

The condition of the home may also play a part. If the property is move-in ready and there are lots of other interested buyers, putting down a larger earnest money deposit may help the buyers win the home.

“Real estate being a game of inches, having a higher earnest money amount will get you ahead only by a little, but that little amount could be the deciding factor if you're buying a property or not,” Miciano said. 

Of course, the earnest money deposit isn’t the only factor the seller is likely considering when deciding whether to accept your offer or not. How much you’re offering for the home and whether it’s an all-cash offer are often larger incentives for sellers.

“We can put 50% earnest down but if our purchase price is 40 to 50% lower than our competitors, we're most likely not going to win that bid,” Miciano said.

How does earnest money work?

If the seller accepts your offer, they will generally take the home off the market until the sale closes. This can often take more than 30 days. 

The purchase agreement between the buyer and the seller will detail how the earnest money deposit is managed. This part of the transaction is typically handled through escrow, where the deposit will be held either by a third-party like an escrow company, a real estate title company, or the seller’s real estate agency. 

Once the sale is finalized, the earnest money can be used toward the down payment or closing costs.

Is earnest money refundable?

Depending on the circumstances, the earnest money deposit is refundable. 

Typically, the conditions for the return of the earnest money are outlined in the purchase agreement. That’s why it’s important to craft the contract very carefully.

Some of the most common reasons for the earnest money to be refunded to the buyer include the following:

●     The buyer is unable to secure financing in a timely manner.

●     The appraisal is lower than the sale price.

●     The home inspection raises concerns that the buyer and seller cannot agree on. 

However, there are circumstances in which the seller can keep the earnest money and the buyers may not have much recourse.

They may lose the money if they miss the deadline on the contract or if they decide to walk away from the purchase due to a change of heart or cold feet or another reason that wasn’t outlined above.  

“There are always conditions attached” to the offer, said Miciano. “The buyer needs to stay within those agreed-upon terms to get their money back.”