What Is Earnest Money & How Much Is Enough?

Buying a new home or selling your existing home can be a fraught, stressful process, especially in a competitive market.

When you approach a home seller to talk about purchasing their property, there’s only one way to ensure that someone else won’t beat you to the sale: having the seller take their property off the market.

Taking their property off the real estate market is risky for the seller, so how can you both agree? Earnest money deposits are the solution.

Let’s take a closer look at what earnest money is, why it’s beneficial, and how much earnest money you may need to put down upfront to secure a competitive home purchase.

How Does Earnest Money Work?

In a nutshell, earnest money is a good-faith deposit put down before you close on a house. It shows that you are serious about purchasing the property ahead of drawing up the paperwork or signing on any dotted lines.

Why bother? In a competitive housing market, every day that a seller leaves their home on the market is another day where someone can swoop in and make a better offer.

Therefore, it is always wise to convince the seller to take their home off the market while you finalize your mortgage loan terms and get all your other ducks in a row.

That’s less than ideal for a home seller looking at a potential buyer. After all, they could risk financial loss if they take their house off the market, only for you to change your mind and go after a different property instead.

Earnest money is a deposit you make toward the seller with a condition: They get to keep the earnest money deposit if you back out of the deal under certain circumstances. That way, both parties in the home deal benefit.

You don’t have to worry about someone else making a more competitive offer on a house you love, while the seller is compensated if you have to back out of the deal for some reason.

Where Is Earnest Money Held Before Closing?

Earnest money deposits are always held in third-party escrow accounts. If the deal goes through, the earnest money deposit is included with the overall payment made to the home seller.

Otherwise, if you back out of the deal, the earnest money deposit gets deposited into the home seller’s account of choice (unless you are refunded the earnest money deposit — see more below).

Depending on your lender, real estate agent, or the title company you use, one of them may provide the account for the deposit while the purchase agreement goes through. Otherwise, an escrow company or real estate brokerage can help.

Why Is Earnest Money Important for Home Sellers?

Put simply, earnest money is vital for home sellers so that they don’t get burned by taking their property off the housing market.

Imagine a new home buyer approaching a seller with a decent offer. The home seller agrees to take their property off the market while the homebuyer readies their mortgage paperwork and acquires some extra money to make the down payment.

However, a few weeks later, the housing market increased in value for home sellers. Even worse, the original homebuyer skips out on the deal, opting for a different property.

In this hypothetical scenario, the home seller has lost valuable time and hasn’t been compensated for removing their property from listing sites.

Earnest money is an incentive for home sellers to take their properties off the market for the benefit of home buyers. It’s also a guarantee that, even if a prospective buyer backs out of the deal, the home seller will be compensated somewhat.

Can Home Buyers Get Their Earnest Money Back?

Yes, in some circumstances. Most earnest money deposits are made with certainly written contingencies in place. If one of the contingencies is activated, the homebuyer can get their earnest money deposit refunded and continue searching for a house.

Common contingencies that make earnest money refundable include:

A home inspection reveals significant housing defects or problems (called the home inspection contingency).
The home’s appraisal amount is lower than the sale price, and the seller is unwilling to renegotiate the home sale price (called the appraisal contingency).
The seller backs out of the deal without warning, so they forfeit the earnest deposit.

Generally, earnest money deposit contingencies kick in when the seller is why the deal falls through. If the prospective buyer is why the deal falls through, the seller usually gets the earnest money deposit.

Some contingencies, like the financing contingency, protect buyers if they can’t secure money to afford a home’s purchase price. Homeowners and buyers should know all contingencies before making an earnest money wire transfer.

Is Earnest Money Always Required in a Home Purchase?

This isn’t always the case in a real estate transaction. Still, a purchase contract usually indicates that earnest money is required for more competitive housing markets and valuable properties.

Generally, the more expensive a property is, the more likely you’ll have to make an earnest money deposit.

How Much Earnest Money Do You Need for a Home Purchase?

The average earnest money deposit amount can vary based on the housing market, mortgage rates, and the house's condition.

As with other things, the better the house and the better the market is for home sellers, the higher the amount of earnest money needs to be. In contrast, a run-down house in a buyer’s market might demand a lower earnest money deposit if it requires one.

That said, the average good faith deposit amount is between 1% and 3% of the purchase price. For more competitive properties and in competitive markets, expect the good faith deposit to be up to 10% of the purchase price.

However, remember that the earnest money deposit is incorporated into the overall purchase price for the property. It’s not an additional fee you need to consider. For example:

You want to purchase a property for $400,000 in total.
The earnest money deposit is $8000 or 2%.
Meanwhile, the seller requires a down payment of 20% total, or $80,000.
When you make the down payment, you incorporate the $8000 already in the escrow account into the amount. So you only need to pay $72,000 for the down payment, as you’ll add the $8000 from the good faith deposit.

First-time home buyers should consider this a core part of the home-buying process. Other fees and closing costs from buying a house can quickly add up to more than you initially anticipated.

Protecting Your Earnest Money Deposit

The best way to protect your earnest money deposit is to put everything in writing and use a trusted third-party escrow account.

Furthermore, review the contract stipulations and contingencies in a good faith deposit contract. That way, you won’t accidentally breach the terms of the good faith deposit contract and lose your money for no good reason.

Lastly, only offer an earnest money deposit if you are certain that is the house you want to buy. Don’t make good faith deposits on various properties you aren’t sure about.

Bottom Line

With an earnest money deposit, you can convince a home seller to take their property off the market long enough for you to explore financing options and secure the best mortgage loan.

That’s easier than ever when you work with Vaster. Our home loan officers strive to put the best options in front of you and help you find your ideal mortgage match based on your needs and budget.

Sources:

Survey: 47% of Americans don’t have home-buying FOMO + the pros and cons of owning a house | The Zebra

What Is Good Faith Money and How Is It Used? | Investopedia

Earnest Money: What Happens When Your Home Purchase Falls Through | Nolo