You found a home, made an offer, and that offer was accepted. Time to move in, right? Not quite yet. You still have to make it through closing. According to data from ICE Mortgage Technology, as of February 2023, the entire process of closing takes an average of 45 days.
The last thing a seller wants is to remove their property from a hot housing market for more than a month only to learn the potential buyer wasn't serious. That's where the earnest money deposit comes in.
What Exactly is an Earnest Money Deposit?
An earnest money deposit is a payment from the buyer that's held by an escrow agent during the home purchase process. Essentially, it’s a good faith deposit the buyer hands over during the homebuying process to show the seller they are committed to buying the property, and the money can be forfeited if the prospective buyer backs out.
An earnest money deposit sort of works like a security deposit that's paid along with an offer. An earnest money check or wire transfer is held by an escrow agent until the real estate transaction is complete, at which point the deposit money is applied toward the sale price.
Why is Earnest Money Important?
Sellers are likely to receive multiple offers in a short timespan, especially in a hot market. There are multiple ways that a seller can narrow down their pool of potential buyers – a solid earnest money deposit is one of them.
If buyers didn’t have to put forth any money upon making an offer, they would be able to make multiple offers on different homes, temporarily removing properties from the market they aren't going to actually buy.
Earnest money can also be used to compensate sellers for the time the home was off the market if a buyer gets cold feet and pulls out for a reason not outlined in the purchase agreement terms.
How Much Are Earnest Deposits?
The amount of earnest money a buyer needs to put forth can vary by region and the competitiveness of the local real estate market. That said, it is usually about 1% to 2% of the home’s purchase price (i.e., up to $8,000 for a $400,000 home).
In a slow market, putting down 1% or less may be enough. In a more competitive market, however, the seller may expect an initial deposit of up to 5%.
In very competitive home buying situations, a real estate agent may recommend an even higher earnest money deposit to prove the buyer is acting in good faith and increase their chances of being chosen. Sometimes sellers may reduce the sales price in return for a larger initial deposit.
Offering too low of an earnest money deposit can falsely signal that you are not serious about buying the home. When deciding how much earnest money to put down with your offer, It is best to take the advice of a realtor who understands all the ins and outs of your local market.
How Does the Buyer Make an Earnest Money Deposit?
A buyer makes an earnest money deposit by personal check, cashier's check, or wire transfer to the escrow account or title company; the money will then be held until the sale is finalized.
Typically, the buyer makes the payment within a day or two after their offer has been accepted, but the timing and process can differ from state to state. Details of how the money should be applied will be spelled out in the purchase contract. In certain states, a buyer may submit a small earnest money deposit with their initial purchase offer, and then submit a larger deposit later. Your real estate agent should be able to walk you through the appropriate steps for your state.
Buyers should be skeptical if they are asked to pay earnest money directly to the seller as it can be difficult to get their money back if something goes wrong. Escrow companies exist to hold money and property during real estate transactions and they exist for a reason: to protect both parties involved in the home sale process. In some states, the real estate agent or an attorney will hold the deposit.
Once the sale has been finalized, the earnest money deposit will be applied toward the buyer's down payment and/or closing costs as outlined in the sales contract.
Is Earnest Money Refundable?
The real estate contract should specify what happens with the initial deposit in different scenarios in addition to the more significant terms of the sale.
That document also includes contingencies, or provisions, that must be met for a sale to go through.
Some of the most common contingencies are:
- A home inspection contingency to ensure the condition of the property matches the listing
- A home appraisal contingency to ensure the selling price is fair
- A financing contingency so a buyer isn't locked into a purchase they can't afford
- Successful sale of the buyer's current home (if applicable)
- Assurance from a title company that the seller actually owns the property
Laws governing whether buyers get their earnest money back when a sale falls through vary by state, but you should work with your agent or attorney to specify in writing what the results of the different contingencies will be.
Buyers who waive their chance to receive their deposit back may be more appealing to sellers, but it's unwise to do so for factors outside of your control, like whether the house passes inspection or appraises to the purchase price.
As a general rule, if the seller calls off the sale, the buyer should be able to recover their earnest money deposit, but if the buyer gets cold feet and calls it off, then they won't. That's why earnest money deposits exist.
Other cases aren't as clear cut, which is why it's important to be comprehensive when writing the purchase agreement. For example, a closing date could be specified with a stipulation about what happens to the earnest money if the papers aren't signed by that time.
If an outcome wasn't specified in the agreement or if there's a dispute, the buyer may need to take legal action to recover their earnest money.
The Bottom Line
Earnest money exists for two primary reasons: to help a potential buyer strengthen their offer on a new home and to protect the seller from losses if a buyer isn’t able to follow through. If you are able to close on a home, your earnest money deposit will go toward the purchase price of the home, so it’s money you would have to spend on the deal anyway.