So you’re on the way to becoming a first-time home buyer. You’ve found the perfect new home and negotiated a good deal with the seller. You make an offer, you’re ready to sign a purchase agreement and start moving toward closing, but now the seller is asking for an earnest money deposit. So what’s this all about?
We’ll cover everything you need to know about earnest money when buying a house, how it works, and what to expect on the road to closing your first property.
What is an Earnest Money Deposit (EMD)?
Earnest money is a deposit a buyer makes to a seller in a large purchase such as a real estate transaction. It shows good faith on the buyer’s part, demonstrating their honest intention to follow through on the rest of the home purchase process.
Typically, a seller takes the property off the market after receiving an earnest money deposit (EMD). This gives the buyer time to complete some of the essential tasks leading up to closing, such as:
- Securing financing
- Selling their current property
- Conducting a title search
- Seeking an appraisal of the property
- Conducting property inspections
Putting money forward shows the seller that the buyer is serious about reaching a deal and hedges the seller’s risk in taking the property off the market during this sometimes lengthy process. Essentially, it disincentivizes wasting the seller’s time.
How Does Earnest Money Work?
A buyer usually submits earnest money, either by check or a direct transfer, into an escrow or trust account. This account is typically held jointly by both parties.
Typically, when signing the sales contract or purchase agreement, the buyer will simultaneously deliver the earnest money payment. The money then remains in the joint account until closing.
Sometimes, the seller may ask that the buyer agree to make continuing earnest money deposits periodically during the sale process rather than in a single lump sum. These recurring deposits would likewise go into a joint trust or escrow account.
An earnest money deposit can also be attached to the buyer’s offer. For instance, if it’s a competitive housing market or you know that many people are interested in the same property, you may choose to submit an earnest money deposit with your offer. This gesture can be a way to show your genuine interest in making a purchase and may help you win the seller’s favor.
Depending on the account type, the earnest money in the account may likely earn interest during the sales process. If that is the case, the ultimate beneficiary of the earnest money, whether that’s the buyer or seller, will likely need to report that interest earned as taxable income.
How Much Should an Earnest Money Deposit Be?
Earnest money amounts can vary significantly but are usually a small percentage of the property’s total sale price. Depending on market conditions and the buyer’s offer, an EMD could range from 1% to 10% of the sale price, although set dollar amounts are also common.
The size of an earnest money deposit is a strong indicator of the buyer’s level of interest and commitment. Therefore, it can be a factor in whether the homeowner accepts their offer.
If you consider earnest money a wager against the buyer acting in bad faith, then a larger deposit signifies greater confidence and commitment from said buyer. It is by no means the be-all and end-all of a good offer, but confidence in the buyer could help sway the seller in favor of the offer.
Is Earnest Money Necessary?
Like many things in real estate transactions, earnest money is negotiable and is not necessarily required to sign a sales contract. Remember, it is primarily a show of good faith, insurance for the seller. Some sellers may accept an offer that includes no initial deposit.
However, as discussed above, negotiating with a sizable earnest money deposit is one indicator of a good offer. Sellers may view offers that don’t include an earnest money deposit unfavorably. Particularly in competitive markets, a buyer trying to avoid this show of faith may quickly take themselves out of the running for many potential deals.
Is Earnest Money Refundable?
Earnest money may or may not be refundable to the buyer, depending on the circumstances. As long as a deal completes without any major upset, there is nothing to worry about as the earnest money goes toward the buyer’s costs (more on that soon).
However, when a deal falls through, the terms of the sales agreement largely determine whether the seller can keep the EMD or if it returns to the buyer. For instance, if the buyer finds another property they like more and decides to back out of the original deal in bad faith, they will likely lose their deposit.
Fortunately for good-faith home buyers, a real estate contract may include various contingencies to back down from the deal and reclaim their deposit. Common contingencies include:
- The buyer is unable to secure financing for the real estate purchase
- The buyer is unable to sell their current home
- Appraisal of the property returns a significantly lower value than the agreed price
- Home inspection reveals significant issues affecting the purchase price
It is crucial to take note of these contingencies before signing a purchase agreement. Not every deal will allow for all of these circumstances. Backing out of the sale for any reason not specified in your contract, including getting cold feet, could result in losing your earnest money deposit.
Does Earnest Money go Toward a Down Payment?
Yes, earnest money usually goes toward the buyer’s down payment or closing costs. Rather than a fee or penalty, an EMD is a demonstration that the buyer is prepared to cover their future expenses.
If the process moves along smoothly and nothing causes the deal to fall through, then the earnest money will form the beginning of a down payment.
How to Protect Your Earnest Money Deposit
Ensure that the terms around your earnest money deposit are clearly in writing in your contract. This documentation should include the buyer’s responsibilities, timelines, and each possible contingency for canceling the sale. It should also detail who will keep the EMD in specific scenarios.
Read through your purchase contract thoroughly to understand the contingencies that protect you as the home buyer and those that protect the seller. If you don’t know what’s expected of you as the buyer, speak to your real estate agent to clarify or adjust the terms.
For example, most contracts and purchase agreements include a timeline for the buyer to make certain decisions to protect the seller against waiting in limbo for an extended time. Be sure that you are comfortable with those deadlines and ready to meet them in order to hold up your end of the contract.
Always use a trusted third party to hold and manage your EMD until the closing date, such as an escrow company, legal firm, or brokerage firm. Don’t deliver your EMD directly into the hands of the seller or real estate broker. A trustworthy seller will be comfortable holding the money in an escrow account until it’s time to finalize the sale.
Good Faith Money and You
If you go into a property deal in good faith, an earnest money deposit is nothing to lose any sleep over. While the value of your deposit can impact whether the buyer accepts your offer to purchase a home, overall, it is a standard procedure that protects both parties.
When the home-buying process moves along smoothly and you follow through with a purchase, your earnest money becomes your first step toward covering your closing costs. If the vetting process reveals a reason you need to back down from the deal, you will usually be able to recoup this money. However, make sure you agree upon each scenario beforehand.
Earnest money is a simple mechanism that protects sellers from buyers wasting their time and covers buyers from a good-faith sale falling through. So long as everyone agrees to clear terms and seeks to uphold those terms, an earnest money deposit is a simple and easy procedure.