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What is Earnest Money and How Much Do You Need?

When you enter into a contract to purchase a home, you and the seller will both sign a contract. This contract does not mean you have to purchase the home, as the home inspection and appraisal could show problems with the property. However, this contract does state that you intend to purchase the home if there are no problems. To show your intention, you’ll have to put down a sum of money known as “earnest money,” also called the “good faith deposit.”

The Risk of Taking a Home Off the Market and the Need for Earnest Money

Selling a home takes time, energy, patience, and money. It can take weeks, even months, to go from listing a home to finally selling the property. When a buyer is found, it’s expected that the seller will take the home off the market; they won’t continue to list the house, show it to buyers, and actively advertise the listing. It may sit on listing websites as “contingent,” but other than that it is completely dormant as the sales process works through.

But what if a buyer backs out?

Imagine you are a seller. After a few weeks of home showings and listing adjustments, you finally find a buyer who wants to purchase your house. So you remove the home from the real estate market and wait. After two weeks, the seller, for whatever reason, decides they no longer want the property. Perhaps they decided the home wasn’t big enough; perhaps they found a different home that better fits their needs; perhaps they could not get financing for the purchase. Whatever the reason, you, the seller, are now back to the starting point. You have to re-list the property and restart the sales process; it could be another month before you find another buyer.

With earnest money, this problem, while not eliminated, is reduced.

What is Earnest Money?

Earnest money is simply a deposit of cash that demonstrates the buyer’s real and honest intention to purchase the property. When an offer is made, the buyer will place a certain amount of cash in an escrow account. This money is held in the account and acts as a security blanket for the seller. If the buyer backs out of the sale, the escrow money is released to the seller, essentially compensating them for the time that the home was off the market.

Earnest money serves a few different functions. For one, it gives sellers a financial compensation if the buyer backs out of the purchase for trivial, arbitrary, or erratic reasons. If there is nothing wrong with the house or the financing, but the buyer simply changes his or her mind, the seller gets to keep the earnest money.

Earnest money also makes the real estate market more efficient and effective. Without it, buyers could make offers to purchase with little regard to whether or not they will buy the home. While they are still thinking about a purchase; still mulling over the property, they could make an offer to ensure that the home is off the market just in case they decide to purchase. This would obviously not be fair to sellers.

Earnest Money vs “Good Faith Deposit”

“Earnest money” and “good faith deposit” are simply two terms that describe the same thing. In most cases, one term or the other is used in the legal writing of the state. So if your real estate agent inquires about your good faith deposit, just know that he or she is, basically, talking about earnest money.

A Deal Falling Through Does Not Automatically Release

If a deal falls through, there are situations when the money is actually released back to the buyer. Each contract will be different, but in most cases if there are significant problems with the home, such as structural damage, a severely-rotten roof, or massive mold issues, the buyer can back out of the deal and have their earnest money released back to them. These issues should have been disclosed from the beginning, so it’s perfectly reasonable for a buyer to expect a return if one of these problems occurs.

Appraisals can also impact earnest money. If the appraisal comes back at a rate much lower than expected, the buyer may be able to get a return.

Generally, as long as the buyer does not back out of the deal for unreasonable or arbitrary reasons, the money can be returned.

Where Does the Money Go After the Deal Goes Through?

If the deal is completed and finalized as planned, the cash you put down as earnest money does not disappear. Instead, the money is released to you and can be used as a downpayment, closing costs, or as fees.

Your real estate agent can help you decide on the right amount for earnest money.

How Much Earnest Money is Appropriate?

The total amount of earnest money will depend on the home, the market, and the buyer’s comfort level with purchasing the home. For most contracts, the buyer will put up roughly 1% to 3% of the purchase price as earnest money. So if you are purchasing a home for, say, $250,000, you can expect earnest money of roughly $2,500 to $7,500. A purchase of $750,000? The total will be around $7,500 to $22,500.

Should You Increase Earnest Money in a “Hot Market?”

If you are in a hot market, one where homes are selling rapidly with massive buyer competition, you may consider using a larger earnest money total to attract the seller’s attention. A large total lets the seller know you are serious and could help secure the home of your dreams.

In the end, the exact amount you put down should be thought over and considered carefully. Using a reliable real estate agent, you can likely select the amount the best fits your specific needs and situation.

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When you are ready for a home loan on your next purchase, give our team a call. We’ll do whatever we can to help you get approved for an excellent mortgage on a world-class home.

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