Think of an earnest money deposit as a way of saying to the seller, “I’m really sincere about wanting to buy your house.” You’re literally “earnest.” You want the property badly enough that you’re willing to put some cash down on the deal before the transaction closes. You're showing that you're not going to have a change of heart.
Earnest money is a good faith deposit, paid upfront at the time the offer is accepted by the seller. You can lose the money if you back out of the deal without acceptable cause. That's the idea behind earnest money: The deposit would serve no purpose if you could simply change your mind and walk away, taking that money with you.
Earnest Money Can Be a Negotiation Tool
Earnest money isn’t a legal requirement when you’re buying a home, but these deposits are standard in the real estate industry. Your offer probably won’t be considered by the seller if you don’t make one, and you can use the deposit to your advantage.
The seller will more than likely take a very close look at your offer if the amount of earnest money you offer is at least a little more than the norm, particularly in a seller’s real estate market where potential homebuyers outnumber the homes that are available for sale. Your offer immediately becomes worthy of a bit more consideration because you’re demonstrating that you’re very serious about buying. It also shows that you have the available funds to make such a deposit, so you’re more likely to close the deal without problems. It gives you a bit more negotiating power to whittle away a bit at that asking price.
The Deposit Is Subject to 'Contingencies'
The key word in all this is that your offer to purchase the home is “accepted.” Your earnest money won’t change hands until the seller accepts your offer and the home buying process begins. You’ll enter into a purchase contract with the seller, and that contract should clearly set forth the circumstances under which you can change your mind and renege on the deal. These circumstances are known as contingencies. A few things have the potential to go wrong after offer acceptance and before you reach the closing table, and some commonly do.
These contingencies are built into the contract, allowing you to take your earnest money back and abandon the home purchase if one or more of them occurs. Common contingencies include the home does not appraise for as much as the purchase price, the buyer fails to get a mortgage loan or that the house fails the home inspection because something is structurally and fundamentally wrong with it. You can also include a contingency that the sale will only go through if you’re able to sell your current home, or when a title search by a title company establishes that there are no hidden, unpaid liens against the property.
Read More: What Does a Home Appraisal Consist Of?
These problems don’t necessarily have to close the door on the sale, but the existing contract would become invalid. You can always try to renegotiate to buy at a price that accommodates the contingency.
How Much Earnest Money Is Required?
There’s no set number or amount for an acceptable earnest money deposit. It can vary by location, by the price of the home on which you’re making an offer and on the current market. A seller’s market might push it up some, while a buyer’s market will bring it down. It’s possible that a seller will build a number into their listing agreement – they won’t consider offers for any less than this amount. It’s also possible that state law can cap or otherwise restrict the amount.
Anywhere from one to two percent of the purchase price is average, however – assuming that it’s not a seller’s market. That could bump it up by another percent. Your real estate agent will know what’s common in your area if you’re working with someone.
Read More: How to Negotiate a House Price in a Buyer's Market
Who Holds the Deposit?
Let’s say you’re making an offer on a $175,000 home. Your earnest money deposit would be somewhere in the neighborhood of $2,600. That’s a somewhat significant amount of cash out of pocket just to get the homebuying transaction up and running, and remember, it’s payable at the time your offer is accepted.
So what prevents the seller from taking the money, then changing their mind and canceling the deal? The seller can’t do that because they're not entitled to contingencies, except in the respect that they can back out of the sale if you don’t actually hand over the money when the deal is accepted or otherwise perform according to your own contingencies, such as by not even applying for financing or failing to have the property appraised.
And the seller doesn't actually get the money in the first place, at least not until the deal closes. Your deposit will most likely be handed over to a disinterested third-party escrow agent to hold onto until that time, although each state might have its own rules for this. State law might dictate how many days can pass before it’s deposited.
Another possibility is that your real estate agent will hold the money in their brokerage’s escrow account. You do not want to write a check to the seller directly at the time your offer is accepted, nor do you have to. You might not be able to get it back in this case if the deal falls through for some reason beyond your liability or control.
When Does the Seller Get the Money?
Your earnest money deposit will be disbursed at closing. It will be applied to your closing costs, or possibly to your down payment. In either case, it’s not additional money paid toward the transaction, over and above the purchase price and the costs of settlement. It will either reduce or eliminate your closing costs, or it’s that much less cash you have to come up with for the down payment at closing. It’s credited toward your bottom line on the purchase.
Can You Lose Your Money?
Your deposit wouldn't be earnest if you could simply change your mind about the purchase and take it back, so yes, you could lose your money if you do that. The seller is entitled to keep the money in this case. Your money acts as a guarantee that you won’t.
You can only break the contract due to one or more of its contingencies not being met, so it’s very important that you make sure those contingencies are built into the contract. You’ll also want to be alert for any “expiration dates” that might apply to contingencies. For example, you might only have 30 to 60 days to get a mortgage and nail down financing. You could potentially lose your earnest money if it takes you longer than this, maybe because you waited too long to apply.
Brokers, agents and escrow companies typically aren’t permitted to release the money to either the buyer or the seller when a deal falls through, at least unless all parties involved are in agreement as to who gets the money. Disputes could end up in court for a judge to decide. Some states’ boards of Realtors have arbitration panels available in this event as well. Your contract should also cite how this type of situation will be handled.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.