What Is Earnest Money When Buying a House?

Earnest money is a “good faith” deposit the homebuyer provides with an offer, to show the seller an intent to follow through on a home purchase. The funds are typically held in an escrow account until closing.

If you haven’t budgeted for an earnest money deposit, this expense may come as a surprise.

Here’s what you need to know about making an earnest money deposit and protecting your deposit.

[Read: Best Mortgage Lenders.]

What Is Earnest Money?

Your earnest money demonstrates to sellers that you are serious about buying their home.

“Earnest money is simply a way to make the buyer have skin in the game,” says James McGrath, licensed real estate broker and co-founder of New York-based real estate brokerage Yoreevo. “Without it, after a contract is signed, the buyer could walk away without penalty.”

Earnest money helps protect the seller if the contract falls through under circumstances not covered by a contingency or a condition that must be met for the sale to continue. If the buyer pulls out to put an offer on another home, for instance, the seller could use the earnest money to market the property again or to cover mortgage and utility payments.

When you make an offer on a home, the offer or contract states how much earnest money you’ll put down.

Once the offer is accepted, earnest money is paid by personal check, certified or cashier’s check, or wire transfer. The deposit is not paid directly to the seller but held in an escrow account, usually with the seller’s real estate broker, title company or escrow company.

The earnest money remains in the escrow account while the details of the home’s purchase are negotiated between buyer and seller.

Once the purchase is finalized, and the buyer and seller have agreed to any contingencies, all that’s left to do is close. The earnest money deposit is often credited toward the buyer’s closing costs or down payment.

[Read: Best Adjustable-Rate Mortgage Lenders.]

How Much Earnest Money Is Enough?

The typical earnest money deposit varies, but it is generally about 1% to 5% of a home’s purchase price. That means a $250,000 home might call for an earnest money deposit of $2,500 to $12,500.

No law or rule requires a certain amount of earnest money to buy a home, but every buyer should prepare to pay a deposit, says Avery Carl, a Tennessee real estate agent.

“Most sellers will not accept an offer without an earnest money deposit,” Carl says. “It’s standard practice to submit a copy of the buyer’s earnest money check with the offer to show seriousness.”

An earnest money deposit could also give homebuyers an edge in a competitive housing market. If you’re stuck in a bidding war, a large earnest money deposit could differentiate you from other buyers.

Bonus: The more earnest money you put down, the less you have to pay out of pocket when you close.

Can You Get Your Earnest Money Back?

Your chances of an earnest money refund are best if you withdraw from a contract based on a contingency. Some common types of contingencies are:

— Home inspection contingency. The inspection reveals serious structural or repair issues.

— Financing contingency. Your mortgage financing falls though.

— Appraisal contingency. The home does not appraise for the purchase price, and other appraisals produce the same result. Your lender cannot give you more than the home is worth.

— Title contingency. A title search reveals problems with the property’s title.

— Home sale contingency. This allows you a certain amount of time to sell your home. If you can’t find a buyer, you are not locked into the purchase.

McGrath says it’s to the buyer’s advantage to include as many contingencies in the contract as possible. This provides multiple ways to end the contract and lose only time and not the earnest money deposit.

The contingencies you include in a contract may depend on how serious you are about buying a particular home and your local real estate market.

In a seller’s market with stiff competition for homes, you might limit contingencies, but a buyer’s market could give you room to negotiate. Of course, the seller could refuse your contingencies — but you should still ask.

When Is Earnest Money Not Refundable?

Some instances allow the seller to keep earnest money, even if a sale isn’t completed. Broadly speaking, that includes any situation not covered by contingencies.

Say you have a change of heart about moving out of the home you now own or rent. Unless the seller agreed to a contingency letting you walk away if you change your mind, then the seller could keep your earnest money.

The same may be true if an unforeseen event changes your mind about buying.

Maybe halfway through buying a home, you cancel your wedding and want to pull the offer you made with the person you had planned to marry. The seller could return your earnest money but wouldn’t have to unless covered by a contingency.

Lastly, keep in mind that you may forfeit your earnest money deposit if you fail to finalize your home purchase within a certain window. This deadline is usually two to three months from acceptance of your offer, but you could try to negotiate a new deadline with the seller, if needed.

[Read: How to Get a Mortgage With No Down Payment. ]

How Can You Avoid Mistakes With Earnest Money?

Because a house can be the largest purchase you will make, a strategy is important. When you’re preparing to buy a home and pay an earnest money deposit, keep these tips in mind:

Work with an experienced real estate agent. You could negotiate a home’s purchase and the earnest money deposit on your own, but a trusted agent can be helpful. Your agent can word the contract appropriately to give you as many contingencies as possible and lower the odds of losing your earnest money.

Take the temperature of the market. Talk to your agent about the local homebuying market and what other buyers are offering as earnest money. Use this information to guide how much you put down as a deposit.

Assess your homebuying budget and financial situation. Before making an offer and handing over your earnest money, determine how much home you can really afford to buy. Check your credit to see how likely you are to obtain the financing you need for the house you want.

Be cautious when removing contingencies. If you’re tempted to leave out certain contingencies to get the seller to accept your offer, consider the consequences. Make sure you know the risks of skipping contingencies and your rights if the sale falls through and you’ve made a large earnest money deposit.

Finally, ask yourself whether you’re truly ready to buy a home, financially, mentally and emotionally.

“The No. 1 reason that earnest money isn’t returned is a buyer’s wishy-washiness,” Carl says. “So be serious when offering.”

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What Is Earnest Money When Buying a House? originally appeared on usnews.com

Update 03/12/20:

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