- Earnest money is a form of good faith deposit that homebuyers put down when making an offer to purchase a property. This financial stake shows the seller that the buyer is serious about completing the deal.
- If the deal proceeds to closing as planned, the earnest money is typically applied to the down payment or closing costs, as expressed in the purchase agreement.
- The earnest money deposit may be refundable if the deal falls through, depending on the terms of the purchase agreement and the reason for terminating the deal.
When buying a home, it is important to consider how your offer to purchase the property may be received by the sellers. There are several ways you can make your offer more appealing, and potentially more likely to be accepted, without offering a higher purchase price. For example, you can get preapproved by a lender[1] to show the seller that you are likely to qualify for the financing needed to complete the purchase (or get a Preliminary Preapproval[2], which uses a soft credit pull rather than a hard credit inquiry). Or you could offer a strong earnest money deposit to demonstrate your sincere interest in the property.
This article answers your pressing earnest money questions, including:
- What is earnest money?
- How much should homebuyers pay in earnest money (and to whom)?
- Is earnest money refundable?
- How can homebuyers protect their earnest money deposits?
What Is Earnest Money?
Earnest money definition: Earnest money is a deposit that homebuyers use to demonstrate their commitment to purchasing a house from a property seller[3]. This deposit is intended to assure the seller that the buyer is acting in good faith, which is why it is sometimes called a good faith deposit. Buyers and sellers can agree to use the earnest money toward either the down payment or closing costs.
Why Is Earnest Money Important?
Earnest money is an important part of the buying process because it assures sellers that a buyer is serious about their intent to purchase.
In many cases, when a seller accepts an offer to purchase their home, they remove the listing from the market while the buyer has the home inspected, has the property appraised, and secures any financing they need to complete the purchase. If the deal falls through, the seller has lost valuable time on the market, during which they could have potentially found another buyer.
The earnest money deposit is intended to minimize frivolous offers from parties without serious intention to complete the purchase.
How Much Earnest Money Should a Homebuyer Pay?
Earnest money amounts vary widely, depending on factors like current local market conditions and expected demand for the individual property. For example, in a strong seller's market, you may want to offer a higher earnest money deposit to make the offer more appealing than any competing offers. But for a fixer-upper with low demand in a slower market, you may be able to offer less. The amount could be a percentage of the offer price, or it could be a flat rate.
If you are working with a real estate professional, they should be able to provide guidance on how much your earnest money should be to be competitive in your local market. In many markets, buyers can expect to put down 1% to 3% of the purchase price as earnest money.
This amount may be paid to a designated third party, like a real estate brokerage, escrow company, title company, or law firm. It is not recommended to pay the deposit directly to the seller.
Who Holds the Earnest Money Deposit While the Transaction Is Processing?
The homebuyer typically pays the earnest money to a neutral third party, such as a real estate brokerage, title company, law firm, or escrow company. The funds are held in good faith escrow, a temporary holding place managed by the third party until the deal is either ready to close or is terminated by the buyer or seller. (As a side note, this good faith escrow is different from the mortgage escrow account homeowners pay into for property taxes and homeowners insurance once their home loan is active.)
The third party disburses the earnest money funds from the escrow account in accordance with the purchase agreement, which outlines the terms and conditions of the transaction. In many cases, the funds are applied to the down payment or closing costs at closing. However, the funds may be refunded to the buyer or released to the seller if the deal falls through, depending on the terms set forth in the purchase agreement.
Is Earnest Money Refundable?
Earnest money may be refundable. Many home-purchase contracts list contingencies, which are conditions that must be met for the deal to close. If one of the contingencies listed in the purchase contract cannot be met and the deal cannot close, the buyer may be entitled to a refund of the earnest money.
For example, if a purchase contract contains a home inspection contingency and a financing contingency, the buyer may be able to have their deposit refunded if the home inspection is not satisfactory or the financing needed to complete the purchase cannot be obtained[4].
When Does the Buyer Lose Their Earnest Money?
Buyers may lose their earnest deposit if they back out of a deal for any reason not listed as a contingency in the purchase contract[3]. For example, if you decide that the home is located too far from your workplace after the offer has been accepted, terminating the purchase contract on those grounds may result in forfeiture of the earnest money deposit.
It is important to note that other factors, like waiving your contingencies or ignoring deadlines built within the purchase contract, can result in the forfeiture of a good faith deposit. Keep reading to learn about ways to protect your earnest money deposit.
What If I Change My Mind as a Buyer?
Changing your mind for reasons unrelated to the contingencies listed in the purchase contract may be viewed as a failure to act in good faith, which could result in the loss of the earnest money deposit. This forfeiture would help to compensate the seller for the time, money, and effort needed to re-list the property and search for another buyer.
How to Protect Your Earnest Money Deposit
Here are four ways to protect your earnest money:
- Pay the earnest money deposit to a reputable third-party (rather than paying the seller directly). This minimizes the risk of losing the deposit if you must cancel the purchase contract due to an unmet contingency.
- Think carefully before waiving contingencies. In a hot market, buyers may waive contingencies to make their offer more appealing to sellers by removing as many hurdles to closing as possible. For example, an eager buyer might waive the home inspection contingency to assure the seller that the deal is not contingent on the condition of the property. However, removing contingencies limits the buyer’s rights to back out of a deal due to a problem with the property or financing. This puts the earnest money at greater risk of being lost because the buyer may not be entitled to an earnest money refund if they attempt to terminate the purchase agreement for any reason aside from the expressed contingencies.
- Pay attention to any deadlines listed in the contract. To keep the deal on schedule, the contract may list specific dates by which contingencies must be met. For example, the contract may stipulate that the buyer must have the home inspected within seven days. Failing to meet such deadlines could be considered a lack of good faith and may result in the forfeiture of the earnest money.
- Pay close attention to your purchase agreement and understand everything that is in writing. The purchase agreement is a binding contract between you and the seller and will detail your responsibilities.
More Earnest Money FAQs
Here are more commonly asked questions about earnest money deposits.
What Is the Purpose of Earnest Money?
The purchase of earnest money demonstrates a buyer’s serious intention to purchase a specific home by backing the purchase offer with cash. This increases the stakes for the buyer and can prevent buyers from making frivolous offers to purchase properties.
Does Earnest Money Really Matter?
Earnest money can make a difference to sellers who are taking a risk by taking their property off the market due to a signed purchase contract. If the deal falls through, the sellers may return to square one of the selling process. So, when given a choice between two identical purchase offers, sellers might accept the offer with the higher earnest money.
Is Earnest Money the Same as a Down Payment?
Earnest money is not the same as a down payment, which is the amount of the purchase price the seller is paying out of pocket (as opposed to financing with a mortgage loan). However, the earnest money may be applied toward the down payment if the deal closes as expected.
What Is an Example of Earnest Money?
Sellers need to sell their homes quickly, so they price them competitively. Knowing there could be multiple offers for this property, a buyer offers slightly more than the asking price and offers a higher-than-standard earnest money deposit to incentivize the seller to accept their offer. The seller accepts the buyer’s offer, and the deal proceeds as expected. At closing, the earnest money is applied toward the down payment.
Who Keeps Earnest Money If the Deal Falls Through?
If the deal falls through, the earnest money may be distributed to either the buyer or the seller, depending on the circumstances, in accordance with the purchase contract.
If the buyer backs out of a deal because a contingency cannot be met (for example, there is an appraisal contingency, and the property appraises for less than the offer price), the buyer may be entitled to a refund of the deposit.
If, on the other hand, the buyer backs out because they changed their mind for a reason unrelated to any contingencies in the contract, the seller may be entitled to the earnest money as compensation for having the property off the market during the contract period.
How Does Earnest Money Relate to a Home Loan?
Buyers can include a financing contingency in their purchase contract, potentially allowing them to back out of a deal, and have their earnest money refunded, if financing cannot be secured.
However, serious buyers would rather obtain the required financing to close the deal than back out and have to start their home search from the beginning. This is why many homebuyers choose to get pre-approved for a home loan early in the home search process.
Buying a home is a big investment, and the earnest money you pay upfront shows the sellers how committed you are to the transaction.
How Does Waiving Contingencies Affect Earnest Money Refunds?
Waiving contingencies removes your contractual protections to back out of a home purchase without forfeiting your earnest money deposit. If you cancel the deal because of issues with financing, the appraisal, or the home inspection without a contingency in place, the seller can typically keep your earnest money deposit.
What Happens to Earnest Money at Closing?
Assuming the purchase is completed as planned, the earnest money is typically applied toward the down payment amount or closing costs due, unless the purchase agreement specifically outlines a different arrangement for the funds.
Connect with a Mortgage Loan Officer to Learn More
Whether you have additional questions about earnest money or want to learn more about the process of applying for a home loan, the mortgage professionals at PNC are happy to assist you. Connect with one of our dedicated Mortgage Loan Officers today by calling 1-855-744-2668. They can answer any of your questions and walk you through every step of your home lending journey.
