Understanding Earnest Money in Real Estate Transactions (2024)

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• Earnest money is a security deposit a buyer pays to show their commitment to buying a house.
• It can be refunded to you under certain circ*mstances and if it's built into your contract.
• An average earnest money payment can be between 1%-2% of the property's value and up to 10% in extreme cases.

When buying a house, you might not be the only one eyeing that dream home. To show you're serious about buying it, you can offer earnest money. This money goes to the seller if you decide to walk away from the house.

Here's how earnest payments work and what to look out for when agreeing to pay a deposit.

Definition of earnest money

Earnest money is a deposit a prospective buyer puts down on a house to show that they're serious about buying it. Once earnest money is paid, the seller pulls that house off the market and the buyer has time to get the house inspected and appraised.

The purpose of earnest money is to "safeguard the interests of the seller, as well as the buyer," says Deonte Cole, a realtor at Keller Williams Realty. If the buyer walks away from a property, the seller gets to keep the earnest money as compensation for their time and costs incurred now that they have to relist the property.

On the other side of the dotted line, the buyer has time to gather all the necessary inspections and appraisals now that the house is off the market. As long as the purchase agreement includes the right contingencies, the buyer will get their money back if an inspection finds significant damage or the house's independent appraisal values the house significantly lower than initially listed.

How earnest money works

Earnest money works as a good faith deposit. You pay it upfront, as a way of showing sellers you're serious about a home. If you go through with the sale, it can go toward your closing costs and down payment.

The process from deposit to closing

Earnest money is agreed upon in the purchase agreement. Once this is paid, typically within three days of the agreement, it is held in an escrow account until the transaction is finalized.

If the house passes all its inspections and appraisals and the sale closes, the money put down as earnest money can go towards the closing costs or down payment on closing day.

Conditions under which it's refunded or forfeited

If the buyer has contingencies in their contract, they may be able to back out of it and see their earnest money refunded. This might happen if problems arise during the home inspection or an appraisal values the house lower than the buying price.

If a buyer decides to move forward with a different house or walks away from a purchasing agreement for any reason beyond what was agreed upon in the contract, the buyer forfeits their earnest money. It goes to the seller, who can use it to cover any losses incurred by taking their house off the market. (These are the biggest risks associated with earnest money and why you'll want to carefully consider how much you offer.)

The importance of earnest money

Earnest money plays an important role in the homebuying process. Primarily, it serves the following two purposes.

Signaling buyer seriousness

Your earnest money deposit indicates how serious you are about a home. If you put down a large earnest money deposit, it tells the seller you're confident you're going to go through with the deal (so confident, in fact, that you're willing to risk a large chunk of change to do it.)

Smaller earnest money deposits don't give sellers as much confidence in your offer and could make it hard to stand out from other buyers.

Protecting the transaction

Earnest money is also a sort of protection for sellers. It gives them money to fall back on if you back out of the deal and they're forced to start from square one again. It can compensate them for the time lost on the market, fees associated with re-listing and re-staging the home, and more.

Determining the amount

Earnest money isn't always a requirement in purchasing a house, however, "it's seldom that you see a transaction where earnest money isn't on the table," Cole says. Earnest money is also generally negotiable.

Factors influencing earnest money amounts

There's no hard and fast rule for calculating earnest money for property purchases. Though the average deposit is 1%-2% of a home's sale price, it can be as high as 10% of the property's value depending on a number of factors, including demand for the property, how long the home's been on the market, your interest in the house, and if the local real estate market is experiencing a seller's market, when demand outweighs supply.

In a buyer's market, where there is more supply than demand, the buyer may be able to get by with a smaller deposit. In markets that are competitive or with a home you really love, offering more is usually the better choice.

How to pay earnest money

You'll typically pay your earnest money right after your offer is accepted — usually within three days. The process looks something like this:

Common practices for making an earnest money deposit

You'll typically make your earnest money deposit via cashier's check, personal check, wire, or money order. It will then be deposited in an escrow account — a type of bank account that acts as a holding service until your deal is ultimately finalized.

If you end up closing on the home, the earnest money will be credited toward your closing costs and down payment. If you back out for reasons not allowed in your contract, though, the earnest will go straight in the seller's pockets as compensation for their loss.

Protecting your earnest money

Your earnest money deposit is often thousands of dollars, so you'll want to take steps to ensure it's safe and, ideally, refundable if you have to back out of your contract. Here's how you can do that.

Ensuring refundability under certain conditions

Once you purchase a house, earnest money can either go back to the new homeowner or go toward your costs as a buyer. As mentioned earlier, you can also walk away from a purchase agreement and get your earnest money deposit back if certain criteria aren't met. However, these contingencies must be stipulated in your contract.

Here are a few common contingencies you might want to consider to ensure your earnest money is refundable.

Home inspection contingency: If a home inspection finds certain problems with the house such as an infestation or mold, a home inspection contingency gives buyers the option to walk away from the property and get their deposit back. These contingencies can also give sellers the option to pay to correct the problems or give buyers the money to make repairs themselves.

Appraisal contingency: If an independent appraiser finds the value of the house to be lower than the property by an agreed-upon amount, a buyer can void the purchase agreement.

Title contingency: A title check confirms through public records that the seller is the actual holder of a property's title. This contingency ensures that if a title check finds any issues with the property's ownership, the buyer can walk away.

There are many other contingencies that can be applied to a purchase agreement. Cole recommends having a real estate agent with you to go through your purchase agreement to identify which contingencies you may need based on your situation, "and see if there's any criteria associated with earnest money that aren't in your favor," he says.

Selecting the right escrow service

Though it depends on your lender, you can often choose your own escrow services for earnest money management. And while fees matter, you should look at other factors when determining who to go with, too.

After all, your earnest money is likely thousands of dollars, so you'll want to make sure you're choosing a good escrow service to safeguard it while you close on your home. Consider a company's experience in the industry, their reviews and reputation, and check with the Better Business Bureau to make sure there have been no serious complaints against them. You should also ask the company about its security measures. How do they protect not only your money, but also your private information and data?

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