Understanding what is earnest money, real estate

When buying a home, you’ll come across various terms and processes, that may confuse you as a first-time buyer. One such concept is earnest money. In this blog, we’ll dive into what is earnest money (real estate). You’ll also learn why it’s important, how much you need to put down, and what happens to it in the home-buying process.

What is earnest money, real estate?

Earnest money, sometimes referred to as a good faith deposit, is a sum of money that a buyer provides to a seller to show their serious intention to purchase a property. It’s a way for the buyer to demonstrate that they are committed to the transaction. This deposit is typically made once the buyer and seller have agreed on the terms of the sale but before the final closing. 

The buyer usually pays earnest money by a certified check, wire transfer, or personal check to a third party handling the escrow. And, the money stays in the escrow account until closing. It’s important that they keep a copy and ask for a receipt.

Why is earnest money important for the buyer and seller?

Earnest money serves several key purposes in a real estate transaction. It primarily assures the seller that the buyer is earnest about purchasing the property. Without this deposit, a buyer’s offer might be seen as less credible, especially in a competitive market.

Once the earnest money is deposited, it solidifies the agreement between the buyer and the seller. It essentially takes the property off the market and prevents the seller from entertaining other offers on the house.

Suppose the buyer backs out of the deal (for reasons not covered by contingencies in the purchase contract). In that case, the seller often gets to keep the earnest money as compensation. It’s for their time and resources invested in the transaction.

How much good faith deposit should a buyer pay?

The amount of earnest money required can vary widely based on several factors. It depends on the local real estate market conditions, the sale price of the house, and negotiations between the buyer and seller. Generally, it ranges from 1% to 3% of the home’s purchase price. In hot markets, it might be higher to make an offer more attractive. A good real estate agent can provide you with guidance on the average earnest money rate in your area.

What is the process to pay earnest money?

Once the buyer and seller sign the purchase agreement, the earnest money is usually deposited into an escrow account held by a third party, such as a title company, real estate brokerage, or legal firm. This ensures the funds are secure and used appropriately throughout the transaction.

Here’s a step-by-step overview of what happens to the earnest money during the buying process:

• After the buyer and seller agree on the terms of the sale, the buyer deposits the earnest money into the escrow account.
• The escrow agent holds the earnest money. Meanwhile, the buyer works through the contingencies in the purchase agreement. These include securing home financing, completing a home inspection, and appraising the property.
• If any of the contingencies are not met, the buyer can typically get their earnest money back. For example, if the home inspection reveals significant issues and the buyer decides to back out, the earnest money goes back to the buyer.
• If all contingencies are met and the transaction proceeds to closing, the earnest money is usually used toward the buyer’s down payment or closing costs.
• If the buyer backs out of the deal without a valid reason, the home seller may keep the earnest money as compensation for the lost time and opportunity.

How to can you protect your earnest money, as a buyer?

To protect your earnest money, it’s important to work with a real estate agent or realtor who is knowledgeable. This will ensure that your purchase agreement includes appropriate contingencies.

Here are some tips to safeguard your deposit:

• Make sure your purchase agreement includes contingencies for home loans, inspection, and home appraisal. These contingencies allow you to back out of the deal and get your earnest money back if certain conditions aren’t met.
• Carefully review the terms of the purchase agreement, especially the conditions under which the seller can keep your earnest money.
• Ensure your earnest money is in an escrow account by a reputable third party or an escrow company. This provides an added layer of security.
• Adhere to all deadlines in the purchase agreement. This is to avoid any breaches of contract that could result in losing your earnest money.

Is a buyer’s earnest money refundable?

Whether the seller will refund the earnest money or not depends on the contingencies in the purchase agreement.

When you make an offer on a home and the seller accepts, the deal isn’t final until certain conditions are met. These conditions are usually detailed in the purchase agreement.

Some of the common contingencies include:

• Home inspection contingency: If the inspection reveals major issues, the buyer can typically get their earnest money back.
• Home appraisal contingency: If the home appraises for less than the purchase price and the buyer and seller can’t agree on a new price, the buyer can usually withdraw and receive a refund.
• Mortgage approval contingency: If the buyer is unable to secure financing, the earnest money is generally refundable.
• Other conditions might be home sale contingency or repairs that need to be made. 

If any of these conditions aren’t met, the buyer has the right to cancel the deal and get their earnest money back. However, if the buyer backs out of the deal for reasons not covered by the contingencies, the seller may keep the earnest money as compensation.

Last thoughts

Earnest money, also called a good faith deposit, is a fundamental component of the home-buying process. It provides security and assurance to both buyers and sellers. Understanding what is earnest money, real estate, and how it works is important. It can help you navigate your real estate transaction with greater confidence.

Whether you’re a first-time homebuyer or a seasoned property investor, it can help you successfully close on your dream property.

Read more: What is commingling in real estate?

Written by Ramona Sinha. December 8, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.