Real Estate Investing

What Does Earnest Money Mean When Closing on a House?

May 15, 2024

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What Does Earnest Money Mean When Closing on a House? 

What does earnest money mean? As a buyer looking for optimal real estate transactions, it’s critical to do everything you can to ensure your offer on your next property stands out. Earnest money bolsters your home offer, showcasing your commitment to purchasing a property. This deposit, typically ranging from 1% to 3% of the home price, can even go higher in competitive markets. 

By offering earnest money, you demonstrate your seriousness to the seller and secure your position in the deal. In this article, we’ll cover all the major questions about earnest money and how to make your offers air-tight in hot markets. 

What is Earnest Money? 

Earnest money is a deposit made to a seller (typically held in escrow) before closing on a house to demonstrate your interest and intent to purchase the property. Earnest money is sometimes known as a ‘good faith deposit.’  

In return, the seller will usually take the home off the market so that no other offers can be made on it. Then during the closing process, the buyer can confirm financing, conduct a property title search, and get an appraisal, without having to worry that another buyer will make an offer on the home. 

Earnest money deposits average around 1-2% of the home’s purchase price, but variation exists across markets, especially in a hot real estate market. 

Why Do Buyers Pay Earnest Money Deposits? 

An earnest money deposit signifies your commitment to purchasing the property and demonstrates to the seller that you’re a serious buyer. It acts as a form of security for the seller, assuring them that you’re dedicated to the deal. 

By providing earnest money, you strengthen your offer and increase the chances of it being accepted. This deposit can influence the seller’s decision and set you apart from other potential buyers or help you get more favorable agreement terms. 

Earnest money is especially important in competitive markets where multiple buyers are making offers on the same properties. If your offer has an earnest money deposit attached, you are more likely than other offers to follow through with the deal—increasing the attractiveness of your offer in the eyes of the seller. 

How Much Should I Deposit? 

How much earnest money should you deposit? Most earnest deposits are around 1-2% of the home purchase price. However, if there’s extremely high demand for the property or a bidding war currently in progress, an appropriate earnest money deposit could be up to 5% or even 10% of the purchase price.  

For example, higher end properties in the Bay area often see buyers making 5% or even 10% deposits. 

If you’re working with a real estate agent, ask for their advice about how much to deposit in your current local market. 

When and How is Earnest Money Paid? 

Earnest money deposits are typically paid after the offer is accepted and the purchase agreement is signed, with payment expected within three days of offer acceptance. However, sometimes earnest money is attached to the offer instead.  

Accepted payment methods typically include personal check, certified check, or wire transfer.  

Note that buyers should never pay earnest money directly to the seller. Instead, buyers should transfer the funds to a neutral third party, such as a bank, escrow company, real estate brokerage, title company, or legal firm. The funds will be held in escrow until the sale closes or a contingency plan is enacted. 

Is Earnest Money Refundable? 

A common question: Is an earnest money deposit refundable? The answer: Sometimes. 

 An earnest deposit is usually refundable if either the seller or buyer backs out of the deal for a reason that falls under a contracted contingency. Common home contingencies and reasons to back out of a property transaction include: 

  • Home inspection contingency. The home inspection failed because there were major problems with the property. 
  • Appraisal contingency. The home didn’t appraise for the price it was listed at, meaning the seller was over-charging. 
  • Home sale contingency. The buyer was not able to sell their current home and therefore don’t have the funds to purchase the new one. 
  • Financing contingency. The buyer was not able to secure financing to fund the purchase of the new property. 

As a buyer, if your reason for backing out of the deal is covered in the contingencies listed in your purchase agreement, then your earnest money is refundable. Your funds will be returned to you from escrow. However, if you back out for a different reason (e.g., you found another property you like better or just changed your mind), then you likely won’t get the deposit back. In this case, the seller will probably get to keep the deposit as compensation for the time and money required to re-list the property and find a new buyer. You could also lose your deposit if you are late on contract deadlines or fail to close by a certain agreed-on date, in which case the deal falls through. 

For these reasons, it’s important to be certain about your intention to go through with a home purchase (as long as financing, appraisals, and inspections go according to plan) before making a potentially non-refundable earnest money deposit. 

How is Earnest Money Used and Allocated in a Transaction? 

If the deal closes, your funds from the earnest money deposit will be applied to the down payment and closing costs. 

Knowing how your earnest money will be utilized can give you confidence and reassurance to put the funds forward in the first place. Your financial contribution up front goes towards the home purchase and can help you ensure a smoother and more successful transaction. 

What is the Difference Between Earnest Money and a Down Payment? 

Since both are terms used to describe a deposit on a home, misunderstanding and confusion around these terms is understandable. However, there are several key differences. 

Firstly, earnest money deposits are much smaller—typically only about 1-2% of a home’s sales price, while a down payment ranges from 10-25%. Additionally, an earnest money deposit does not necessarily initiate the transaction or begin the home purchasing process. Rather, it is an act of good faith showing the buyer’s commitment to follow through with the rest of the down payment later. While often refundable, earnest money is not guaranteed and varies based on contract terms. Earnest money is also negotiable and not mandatory. 

How Can I Protect My Earnest Money? 

If you’re nervous about submitting money up front before a contract is finalized, you aren’t alone. Here are a few steps you can take to protect your earnest money deposit and not lose earnest money if things don’t work out: 

  • Make and review the home purchase contract carefully. 
  • Include all contingencies. 
  • Use an escrow account instead of sending the money to the seller directly. 
  • Follow all terms, conditions, and deadlines of the agreement. 

If you follow these steps and have to back out of the deal for a justified reason outlined in one of your contingencies, then there’s a good chance you’ll get your earnest money deposit back. 

Conclusion 

Earnest money is a vital aspect of closing on a house and showcasing your commitment as a buyer. Remember to protect your earnest money deposit by consulting with a real estate agent or attorney and clarifying all terms of the agreement (including contingencies) before sending over any money.

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