What is Earnest Money?

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What is earnest money or earnest money deposit?

Earnest money is a deposit that a buyer makes to a seller prior to closing to show that they are serious about the purchase.

It is also known as a ‘good faith deposit’ as the seller removes the listing from the market while the closing process takes place. Earnest money deposit allows the buyer of the home some additional time to secure financing, conduct a title search & insurance, various inspections, repairs, and get the property appraised.

How much earnest money should be offered?

Typically, earnest money deposits are 1% - 3% of the sale price. For example, on a $400,000 final home price, the earnest money could be between $4,000 and $12,000.

The exact amount of earnest money required depends on the market, if it is a seller’s market where there are excess buyers, you might require more earnest money. Whereas, if it is a buyer’s market with limited buyers, you might require a very small deposit if any.

Is earnest money refundable?

Yes, earnest money is refundable depending on which contingencies are included in the purchase agreement. The contingencies will include scenarios in which you can walk away from the deal with your earnest money deposit. The three most common contingencies:

  1. Financing Contingency: This contingency is there to protect buyers if they are rejected for a mortgage by their lender. If you were pre-approved for a mortgage, and then were rejected in the final approval process, this contingency allows you to get a full deposit refund. In extremely difficult markets, sellers will not like a financing contingency as it can prevent them from selling the house if you are not approved by your mortgage lender.
  2. Appraisal Contingency: Appraisal is the process of getting a home valued by an unbiased professional. If the appraised value comes lower than the listing price, lenders can back out of the mortgage, leaving you without financing. Therefore, this contingency is essential to ensure the listed price is at least equal to the appraised value of the home.
  3. Inspection Contingency: Home inspections are essential, this can include a full inspection of the basement, roof, quality of fittings, backyard and even flooding checks. If a certain aspect of the home is extremely damaged or risky which were not disclosed earlier, this contingency allows you to back out of the transaction with your deposit. If the repair is minor, then you can work with the seller to reduce the home price.

When is the earnest money deposit not refunded?

Earnest money is not refunded if the buyer breaks any of the contingencies in the purchase agreement such as if you miss the deadlines to finance the transaction.

There are certain cases when the buyer can agree to a non-refundable earnest money deposit in order to stand out among buyers. In this case, if the deal does not go through for any reason, the deposit is not returned.

Earnest Money Real Estate FAQ

How does the earnest money deposit work?

The earnest money deposit is kept in an escrow account once the seller has accepted your offer. The funds act as a good faith purchase to assure the seller the buyer is going ahead with the transaction.

The purchase agreement will state how much earnest money is being deposited and here it will be held. When the transaction is complete and the sale is done, the funds can be returned or applied to the purchase price or closing costs.

There are three scenarios as to the working of an earnest money deposit:

  1. Deposit Forfeited: In this scenario, the earnest deposit is not refunded. For example, Bob really likes 3 houses and cannot choose between one, Bob can put an earnest deposit for all 3 homes. All 3 homes are removed from the markets for Bob, in the end, Bob picks only one, however, he loses his earnest deposit for the other 2 homes in the process. The other 2 sellers are compensated for lost money and time.
  2. Home Purchase: In this scenario, the earnest money goes towards closing costs or the down payment. For example, Bob really likes 1 house, he wants this to be his forever home and therefore, puts an earnest deposit to compel the seller. The seller accepts his offer, resulting in his earnest deposit going towards his closing costs or down payment.
  3. Contingency Failure: In this scenario, the earnest deposit is refunded as a result of a breach in one of the contingencies. For example, Bob really likes 1 house and puts an earnest deposit. However, in the home inspections, they find severe water damage and pipe failure. Bob has the option to cancel the transaction and get a full refund on his earnest deposit.

Should you pay earnest money?

It is important to understand that earnest money is not a requirement in the home buying process, it is more of a good-faith gesture. However, in competitive markets where sellers are getting multiple offers on their home, it can be a key criterion to stand out. It assures the sellers that you will not drop out of the sale and cause hardship after the entire closing process is done.

If you are serious about the home, an earnest money deposit is a good decision as it is essentially prepaying some of the closing costs or down payment. If you are unsure about the home, or about the mortgage then you should consult a real estate agent whether it is the right decision to give a deposit or to make it a refundable deposit.

What is the contingency of the sale of existing home?

This is a less used contingency where the buyer can back out of the purchase of a home because their existing home has not sold. This contingency is not used often as most sellers will not accept such a contingency as it reduces the chances of the sale proceeding. If you are considering this contingency look into bridge loan financingwhich can help overcome this contingency.

What is the difference between an earnest deposit and a down payment?

An earnest deposit is a good faith payment in order to improve your chances of purchasing a home. The seller removed the listing preventing other buyers from purchasing the home. It is not required by the buyer.

Whereas, the down payment is an upfront amount that is paid to purchase the home. It is a requirement in most mortgage programs so be sure to check the minimum down payment requirementsfor different loan programs and lenders.

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