Earnest money is a deposit typically paid at the time you enter into a contract on a home. It indicates your commitment to follow through on a home purchase.
But if you're not expecting to pay earnest money on top of other homebuying expenses, such as closing costs or the down payment, it may come as a surprise. Understanding what earnest money is, why you have to pay and when you can get earnest money refunded is an important first step in the homebuying process.
What Is an Earnest Money Deposit?
Earnest money is a deposit a homebuyer pays to a home's seller as a show of good faith. The amount you'll pay for earnest money varies, but typically it's 1% to 5% of the home's purchase price. A $250,000 home might require an earnest money deposit of $2,500 to $12,500. When you make an offer on a home, the offer or contract will spell out how much of an earnest money deposit is required.
Once the offer is accepted, earnest money is paid by the buyer either by personal check, certified or cashier's check, or wire transfer. The deposit isn't paid directly to the seller. Instead, it's held in an escrow account, usually with the seller's real estate broker, title company or escrow company. The earnest money remains in the escrow account while the details of the home's purchase are negotiated between the buyer and the seller.
Once the home's purchase is finalized and the buyer and seller have agreed to any contingencies, all that's left to do is close. The earnest money deposit is credited toward any closing costs associated with completing the sale.
[Read: Best Mortgage Lenders.]
Why Sellers Require Earnest Money
Essentially, an earnest money deposit is a way to signal to a home's seller that you're serious about buying it.
"Earnest money is simply a way to make the buyer have skin in the game," says James McGrath, licensed real estate broker and co-founder of New York-based real estate brokerage Yoreevo. "Without it, after a contract is signed, the buyer could walk away without penalty."
Earnest money offers a measure of protection to the seller in case the contract falls through under circumstances not covered by a contingency. That money could be used to compensate the seller for any costs associated with a failed sale. For instance, if the buyer pulls out because they decide to make an offer on another home, the seller could use the earnest money deposit to make up for what they'll need to spend to market the property again, or make mortgage and utility payments.
An earnest money deposit could also give homebuyers an edge in a competitive market. If you find yourself stuck in a bidding war with another buyer over a home, offering a large earnest money deposit could persuade the seller to favor your offer. And the more money you put down for an earnest money deposit, the less you may have to pay out of pocket later at closing.
There's no law or rule that requires earnest money to buy a home, but every buyer should be prepared to pay it, says Avery Carl, a real estate agent based in Nashville, Tennessee.
"Most sellers will not accept an offer without an earnest money deposit," Carl says. "It's standard practice to submit a copy of the buyer's earnest money check with the offer to show seriousness."
Carl says earnest money offers another protection to home sellers by warding off casual home shoppers. When cash is required up front to make an offer, it can deter the "tire kickers" who may not be 100% committed to making a move forward on a home. This helps the seller avoid wasted time.
Is Earnest Money Refundable?
While earnest money can protect the seller, it's also important to protect yourself as the buyer. That's where including contingencies in your home offer contract comes into play. Contingencies can allow you to get your earnest money deposit back if you end up not buying the home.
Some of the most common contingencies include:
-- Returning your earnest money and canceling the sale if you're unable to get financing.
-- Canceling the sale because the home inspection uncovers a serious structural or repair issue.
-- Ending negotiations because a title search reveals issues with the property's title.
-- Canceling the sale because the home appraises too low and subsequent appraisals produce the same result.
-- Making the purchase contingent on your being able to sell the home you currently own.
You should also include a contingency that allows you to get your money back if the seller decides to back out of the sale for any reason.
McGrath says it's to the buyer's advantage to include as many contingencies in the contract as possible. This would allow you multiple outs in which you could end the contract without being penalized through the loss of your earnest money deposit. You could walk away from the home with your deposit and only lose time, not money.
The type of contingencies you include in a homebuying contract may depend on how serious you are about buying a particular home and the state of the local market. If there's stiff competition for homes and it's a seller's market, then you may consider limiting contingencies. On the other hand, if it's a buyer's market, then you may have more room to negotiate.
Of course, the seller could refuse your contingencies. But you should ask.
Also keep in mind that there may be deadlines for earnest money to be refunded. This may be two to three months within making the offer and having it accepted. If the home purchase isn't finalized in that window, you may forfeit your earnest money deposit. You could, however, attempt to negotiate a new deadline with the seller.
When Earnest Money Isn't Returnable
While there are several scenarios where a buyer could get their earnest money deposit refunded, there are some instances where the seller could keep the money even if the sale isn't completed. Broadly speaking, that includes any situation not covered by contingencies.
Say you have a change of heart about moving out of the home you currently own or rent. Unless your seller agreed to a contingency that says you could walk away from the purchase because you change your mind, they'd be entitled to keep your earnest money. The same may be true if something unforeseen happens that changes your mind about buying.
For instance, say you're engaged and decide to put in a home offer together. But halfway through the homebuying process, you end up canceling the wedding and no longer want to buy the house. The seller could choose to return your earnest money, but they wouldn't be obligated to unless it's covered by a contingency.
[Read: Best FHA Loans.]
Tips for Paying Earnest Money When Buying a Home
Any time you're spending cash to make a large purchase, it's important to have a strategy. When you're preparing to buy a home and pay an earnest money deposit, keep these tips in mind:
-- Work with an experienced, trusted agent. While you could negotiate a home's purchase and the earnest money deposit on your own, having a trusted agent on your side can help. Your agent can word the contract appropriately to give you as many contingencies as possible and minimize the odds of losing your earnest money.
-- Take the temperature of the market. Talk to your agent about what the local buying market is like and what other buyers are offering for earnest money. Use this information to guide how much you offer for an earnest money deposit.
-- Assess your homebuying budget and financial situation. Before making an offer and handing over your earnest money, determine how much home you can really afford to buy. Check your credit, debt and income to get a sense of how likely you are to get approved for a mortgage so you're not wasting time making an offer or putting up a deposit on a home you're not realistically able to buy.
-- Be cautious when removing contingencies. If you're tempted to leave out certain contingencies to get the seller to accept your offer, consider the consequences first. If you're offering a large amount of earnest money, you need to understand the risks involved with skipping contingencies and what rights you may or may not have to get that money back if the sale falls through.
Finally, ask yourself whether you're truly ready to buy a home, financially, mentally and emotionally.
"The No. 1 reason that earnest money isn't returned is a buyer's wishy-washiness," Carl says. "So be serious when offering."
More From US News & World Report