February 20, 2020

How Does an Earnest Money Deposit Work?

If you're serious about home buying, you'll need to show the seller that you intend to go through with the purchase, assuming you secure financing and the home inspection goes as planned. That's where an earnest money deposit comes in.

What is earnest money?

In a real estate transaction, "earnest money" is a good faith deposit given to the seller that indicates the buyer's intent to purchase a home. While earnest money is not necessarily required, most sellers won't go under contract without it. The amount of earnest money varies and is negotiable, but usually falls between 1% and 2% of the purchase price. In competitive markets, sellers might request more than that.

Here's how earnest money deposits typically work:
  1. The buyer delivers the earnest money when entering into a purchase agreement with the seller.
  2. The seller takes the home off the market while it undergoes a home inspection and appraisal.
  3. The earnest money is kept in an escrow account held by the title company or real estate brokerage firm.

Depending on the home buyer's ability to get financing and the results of the home inspection and appraisal, one of three things will happen next:
  • If the buyer proceeds with the home purchase, the earnest money is put towards the down payment and closing costs.
  • If the seller terminates the deal for any reason, or if the buyer backs out because of contingencies included in the contract, the earnest money gets returned to the buyer.
  • If the buyer decides not to purchase the home for a reason not provided for in the contract, the buyer forfeits the earnest money.

Is earnest money deposited right away?

Usually, the title company will cash your earnest money check immediately to ensure you have the funds and don't spend the money on something else.

You'll typically hand over a certified check when you sign the purchase agreement. Sometimes buyers will submit earnest money with their initial offer. Either way, you'll need to ensure you have the funds in your account to cover the amount.

Can you get your earnest money deposit back?

Yes. Any breach of contract allows you to get your earnest money back from the escrow company.

Examples of these scenarios:
  • The seller fails to deposit the earnest money.
  • The buyer is denied a loan for the home and there is a financing contingency in the contract.
  • The home appraises for less than the purchase price and the seller will not negotiate the price.
  • The home inspection reveals flaws that the seller refuses to fix and there is an inspection contingency.
  • The seller failed to disclose issues with the home that they were obligated to disclose.
  • The buyer can't sell their home in time, and a contingency provides for the buyer to back out.
  • The title search uncovers issues such as a lien on the property.
  • The seller walks away from the deal.

Typically, the buyer and seller will negotiate resolutions to any issues that come up so that the sale can go through as planned. For example, if the home inspector finds that major repairs are needed, the buyer and seller can negotiate whether the purchase price will be reduced or the seller will fix the issues.

When can the seller keep the earnest money?

You can always walk away from purchasing a home if you have a change of heart. However, you might lose your earnest money deposit if you're under contract. A seller can keep your earnest money for any of the following reasons:
  • You discover issues and want to back out after the due diligence period has ended.
  • You back out for any reason not listed as a contingency in your contract.
  • You don't close on time and your contract has a “time is of the essence” contingency.

How to ensure you don't lose your deposit

Depending on the purchase price of the home you intend to buy, you could be forking over a lot of cash for your earnest money deposit. Here's how to make sure you don't lose that money:
  • Be sure the home is right for you before you sign a contract. Take as many walkthroughs as you need with your real estate agent to make sure you want the home. If you have a change of heart once you're under contract, you could lose your earnest money.
  • Make sure all necessary contingencies are listed in your contract. You'll need contingencies for the home inspection, home appraisal, and title search. Depending on your situation, you might also need contingencies for financing and the sale of your existing home.
  • Read the contract carefully and follow the terms. That includes making sure you get everything done by the deadline. If you take too long to schedule your home inspection, for example, you could lose your earnest money.

It can be scary to hand over money to a seller when so many variables are still unknown. As long as you abide by your sales contract, your earnest money will either go towards your down payment or be returned to you.

And when you finally close and get the keys to the new home of your dreams, it will be well worth the anxiety that came with the home buying process.