What Is Earnest Money in Real Estate Transactions? 

Earnest money is the money a property buyer must put down to demonstrate commitment to purchase a property. When the purchase agreement is signed, sellers will have to take their property off the market. Earnest money prevents buyers from signing purchase agreements on multiple properties and pulling out without good reason before the sale. 

This initial deposit gives the buyer time to secure financing for the property and perform all necessary due diligence. For the seller, the earnest money offers an assurance that they will be compensated for the time the property was off the market if the buyer walks away. Read on to discover what earnest money is and how it affects real estate transactions. 

Understanding Earnest Money Deposit

Earnest money is a deposit a buyer makes to show their sincere intention to purchase a property. It's a way for buyers to demonstrate their commitment to the seller. Earnest money is required for most real estate transactions, including purchasing a home, property or other real estate. Earnest money, sometimes called a good-faith deposit, is usually made to an escrow account and held until the purchase is finalized.  

Depositing earnest money gives a buyer time to perform due diligence, such as a title search and property inspection while securing the property with a purchase agreement. The buyer has time to fulfill other contingencies like an appraisal contingency and securing financing. 

What Is the Difference Between Earnest Money and a Down Payment?

The difference between earnest money and a down payment is where you'll pay the funds. Earnest money is a deposit made for the seller and typically equals 1% to 2% of the total purchase price but could be up to 10% of the sale price in particularly competitive markets. You deposit earnest money into an escrow account, not directly with the seller. When the sale is finalized and the purchase contract is signed, an escrow deposit can be transferred to the seller, or to the lender to cover closing costs or down payment. 

A down payment is made to the mortgage lender on mortgage approval. While you could get a 0% down mortgage, in most cases, you'll need to pay 3.5% to 20% of the total purchase price.

How Does the Earnest Money Work?

Earnest money is a type of financial commitment demonstrating the buyer's seriousness about the property purchase. Earnest money is deposited into an escrow account and held there to protect both parties until the transaction closes. When you sign the initial purchase contract, you will include a clause about the earnest money and where it's held. 

The contract will outline the conditions for refunding the amount. If the buyer breaks the contract for any reason other than the contingencies or conditions outlined in the contract, they won't get their money back. Agreed-upon contingencies protect the buyer in case major issues with the property are discovered. Common contingencies include the property passing an inspection or that the title is free of any liens or encumbrances such as encroachments not previously disclosed by the seller. 

In general, earnest money will be returned to the buyer if the seller terminates the deal. However, the seller will get to keep the earnest money if the buyer unreasonably terminates the purchase agreement.

For example, if you plan to purchase a home for $300,000, the earnest money could be 2% of the purchase price, or $6,000. You'll deposit that into an escrow account with the title company, bank or escrow service. You will then go through the process of organizing a property inspection, title search and finalizing mortgage approval. At closing, when you sign the purchase contract, the money held in escrow will be transferred to the seller, or to cover closing costs, based on the agreement stated in the contract.

Why Should You Pay Earnest Money?

Paying earnest money helps secure the property while you perform due diligence to finalize the purchase. Earnest money demonstrates to the seller that you're serious about the property. In most cases, a seller won't enter a purchase contract without an earnest money payment.  

How Much Earnest Money Should You Put Down?

The amount of earnest money you should put down varies, but it's typically around 1% to 3% of the purchase price. It's always a good idea to check with your real estate agent or attorney to determine the appropriate amount for your situation. In highly competitive markets, for example, a buyer may offer additional earnest money to help improve their offer. 

Is Earnest Money Refundable?

In most cases, earnest money is refundable. This depends on the terms outlined in the purchase agreement. If a buyer simply decides to back out of a deal, earnest money generally is not refundable. If the property doesn't meet contingencies outlined in the purchase contract, the earnest money is refundable. If the seller backs out of the deal, the buyer will get their earnest money back in most cases. 

How to Protect Your Earnest Money Deposit

Protecting your earnest deposit involves two essential steps. First, you need to have the agreement and contingencies, including the earnest money deposit amount, specified in a legal contract. Second, you should not send earnest money directly to the seller or the seller's agent. 

Instead, you'll deposit the earnest money in an escrow account until the purchase contract is signed. It's important to read and understand the contingencies for which you'll get the earnest money back and to organize the appropriate due diligence. Other tips to protect your earnest money include:

• State contingencies: Understand the contingencies and make sure to include contingencies for financing and inspection. 
• Sign a contract: All terms should be in writing and signed by both parties to prevent misunderstandings. 
• Understand the terms: Read and abide by the terms of the contract. For example, the contract may stipulate the time you have to complete the home inspection or other deadlines. If you fail to meet them, you could lose the earnest money.  
• Use an escrow account: Never deposit earnest money directly in the seller's account or send it to the seller's agent. They could decide to keep the funds even if the transaction doesn't go through. Instead, deposit the funds in an escrow account and specify when the funds can be released. 
• Choose a reputable company: Make sure the deposit is handled by a reputable third party, such as a well-known real estate brokerage, escrow company, title company or legal firm. Be sure to verify that the funds are held in escrow and get a receipt! 

What to Do if You Can’t Afford the Earnest Money? 

If you cannot afford the requested amount of earnest money, it's essential to have an open conversation with the seller or their representative. They may be willing to consider alternative options or work out a solution that fits within your financial means. For example, they may ask you to make a smaller earnest money down payment, use option agreements or make monthly payments until the purchase contract closes. 

Earnest Money in Real Estate Transactions

Earnest money demonstrates to sellers that you're serious about the real estate transaction. The purchase agreement will outline the earnest money amount and contingencies that must be met to close on the property. Assuming those contingencies are met, the earnest money can go toward the closing costs or property down payment. On closing, the escrow company will transfer the earnest money to the appropriate account. Ready to consider other purchases? Learn more about real estate investing or how to buy a rental property here.  

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