What Is Earnest Money?

What Is Earnest Money? article image.

Earnest money, also known as a good-faith deposit, is a payment that accompanies a formal purchase offer on a house. As the name implies, a good-faith deposit is meant to convey to the seller that you, the homebuyer, are serious about your offer and that you have funds available to follow through on a purchase.

Making a good-faith deposit is not mandatory when bidding on a home, but it is customary in many housing markets. Sellers may even dismiss offers that don't include earnest money. A good-faith deposit is advisable as a gesture of commitment when a seller is likely to receive multiple offers on a home, and a sizable deposit may even help you stand out among rival buyers.

The amount of a good-faith deposit varies by region, but typically ranges from 1% to 3% of the offer price. Your agent or another real estate professional can advise you on how much is customarily offered in your market, and whether it's strategically wise to go above the typical amount. Be aware, however, that you could have to forfeit your deposit if you don't complete the sale, as discussed (more on that below).

How Earnest Money Deposits Are Managed

While a good-faith deposit is not a legal requirement, there are laws that govern the handling of any earnest money you put down. A standard offer letter or purchase contract (documents that are one in the same in some jurisdictions) will typically include language spelling out how the deposit is to be managed. Here again, a real estate professional can assist with the details.

Local laws may differ somewhat, but these conditions typically apply:

  • If the seller declines your offer, the check will be returned to you.
  • If the seller accepts your offer, your good-faith deposit typically must be placed in an escrow account.

Once earnest money is deposited in an escrow account, the following conditions are generally applicable:

  • If the sale goes through as planned, the good-faith deposit is treated as part of your down payment on the house.
  • If the sale doesn't go through, the wording of your contract will determine whether you get the deposit back.

How You Can Lose Your Deposit (and When You Won't)

If you simply change your mind about buying the house and withdraw your offer, you should expect the seller to keep your good-faith deposit. This is considered fair compensation to the seller for taking the house off the market and missing out on other potential sales.

The following circumstances can also lead to forfeiture of a good-faith deposit, unless you put language in your offer letter or sales contract that allows you to back out of the deal (and get your earnest money refunded) if they occur:

  • You fail to secure financing sufficient to complete the purchase offer. (This may include instances where the lender's property appraisal values the house at less than your purchase offer.)
  • You are unable to sell your current home and must withdraw your offer.

Generally speaking, you can expect your deposit to be returned if the seller calls off the sale for any reason, or under the following circumstances:

  • A home inspection uncovers a defect that adversely affects the home's integrity or market value.
  • One or more liens come to light which the seller must clear before selling the house. (Sellers can settle some liens after closing, in which case there'd be no need to halt the sale.)
  • The seller fails to complete actions agreed upon as contingencies of the sale, such as making promised repairs, replacing or leaving certain appliances in place, removing undesired material from the property, and so on.

In today's hotly competitive real estate market, many sellers are waiving their rights to home inspections and opting to minimize offer-letter contingencies that could protect their good-faith deposits. That may be a smart strategic move when you're trying to nail down your dream home, but if losing your earnest money could delay your ability to make another offer, think twice about putting your deposit at undue risk.

The Bottom Line

Be honest with your real estate professionals about your financial situation and your attitude toward risking your good-faith deposit. Ultimately, it's important to do what feels right to you.

If you're getting ready to buy a house, check your credit report and credit score to see where you stand. You may want to take steps to improve your credit before submitting a mortgage application. Happy house hunting.