What Is Earnest Money And Why Do I Need It? (2024)

Your financial priorities before you buy a home should include saving enough money for a down payment, getting pre-approved for a loanand figuring out your estimated monthly mortgage payment. But make sure you plan for another, lesser-known expense, too—earnest money.

In nearly every home purchase, buyers are required to provide a deposit meant to signal their intent, or good faith, to buy a home. This is called an earnest money deposit and it occurs when the seller accepts the buyer’s purchase offer. Unless you’ve planned for it, this could be an unwelcome surprise, especially if the down paymenton your new home is tied to the sale of your current residence.

Here is what you need to know about earnest money and its important role in the mortgage loan process.

How Earnest Money Works

Sellers want you to provide earnest money when they accept your offer because it shows you’re serious about the purchase. In exchange, they will take the home off the market and assume you will move forward with the appraisal, home inspection and other steps toward closing on the home.

Your real estate agent and the seller’s agent will negotiate how much earnest money you will have to pay and how, when and where the money will be sent. Buyers usually provide a check or money order to cover the earnest money,although it’s becoming more common to transfer the money digitally.

The earnest money should be held by a third party—usually a title company or in an escrow account—until closing, when the money can be used toward closing costs or the down payment.

How Much Earnest Money You’ll Need

Your earnest money amount will either be a percentage of the purchase price or a fixed amount, based on common practices in the market where you’re buying the home.

If the earnest money amount is percentage-based, you’ll usually pay between 1% and 5% of the purchase price. If you’re buying a newly built home, your earnest money amount might be higher than for a previously owned home.

If the housing market is intensely competitive, sellers might ask buyers to provide above-market earnest money. If buyers want to get an edge on other bidders, they could provide more earnest money than expected to show how serious and financially stable they are.

How Earnest Money Refunds Work

A home purchase can fall through for many reasons, such as structural problems in the home, a low appraisal value or a financial issue that prevents the buyer from closing on the mortgage. Buyers will be able to get most, if not all, of their earnest money back if they have the appropriate contingency in the sales contract.

Contingencies could cover multiple scenarios, including:

• Making the purchase of the new home based on the sale of your current home
• A home inspection that indicates several major problems, including ones you can’t afford to fix and/or the seller won’t address
• A low appraisal that puts your loan approval in jeopardy because your mortgage loan is based on the home being valued at a designated amount
• Problems with the title on the home to be purchased
• Your own financial difficulties, which could be caused by the loss of a job or health emergency

You’re much more at risk if you decide to waive contingencies in the purchase contract. Some sellers might request a contingency waiver if they’re getting multiple offers in a competitive market or if they get an all-cash offer.

If you want to waive contingencies, make sure you get as much assurance as possible from the lender that your loan will get approved. But even with that, you’ll also need to hope the home inspector doesn’t discover major issues in the home and that the appraisal will come in at the required amount.

The seller might be able to keep the earnest money if you are not able to complete the purchase process—including the appraisal and home inspection—according to the time period detailed in the contract. This is more likely if the seller puts a “Time Is of the Essence” clause in the contract, which makes the deadlines a clear requirement.

Also, if you decide to walk away from the purchase just because you don’t want to go through with it anymore, you’ll lose the earnest money.

Earnest Money Vs. Good Faith Deposit

Earnest money is sometimes called a “good faith deposit.” However, there also are good faith deposits that are not earnest money, but instead are payments made directly to a lender.

When you make a good faith deposit to a mortgage lender, it covers some of the expected costs of the mortgage lending process and gives the lender more confidence that you will move forward with the loan. A deposit could be several hundred dollars to cover costs of the appraisal and credit report that the bank orders.

But if you decide not to pursue the mortgage loan or choose to work with another lender, it’s likely you won’t get that deposit back.

What If You Can’t Afford Earnest Money?

If you’re a first-time homebuyer and have a sizable down payment ready for your home purchase, coming up with earnest money shouldn’t be a problem.In fact, about 60% of homebuyers fund their mortgage down payment from their savings.

But what if you need to sell your current home before you can purchase a new one, and don’t have a lot of cash available? You could get a gift from a friend or family member to cover the earnest money. All of this will need to be documented with the lender, however. They will ask to see your bank account statements and check on any major deposits that aren’t verified, so it’s best to be upfront about the source of your funds.

It’s also possible to ask your real estate agent to request a waiver of the earnest money requirement. This is likely most successful when the real estate market is slow and the seller is in a hurry to make a deal.

What Happens to Earnest Money at Closing

It’s very likely you will apply the earnest money toward the down payment or to cover closing costs during the closing of your mortgage loan.

Most buyers want to provide as much of a down payment as possible to avoid mortgage insurance, lower their monthly payments and possibly get a better interest rate, which is why it makes sense to direct the lender to add the earnest money amount to the down payment at closing.

Even if you don’t need the earnest money to help you make a down payment at closing, you still might need to use the money to pay for closing costs such as initial property taxes and homeowners insurance.

Indeed, earnest money can be an unexpected expense at the beginning of the mortgage loan process, but it’s a valuable asset at the end of it.