Earnest Money Definition: What It Is & How It Works

In today’s crowded real estate market, ensuring your offer on a home will stand out is crucial to securing the deal. There are several ways to let a seller know you’re serious about buying a home, and putting down an earnest money deposit is one of them.

Since the complex real estate universe and terminology alone can make anyone’s head spin, in this article, we will break down what earnest money is, how it works and how to use the earnest money deposit to your advantage when buying and even selling a house.

Earnest Money Definition: What Is Earnest Money, Exactly?

Earnest money is a deposit made to a seller to show that the buyer is serious about purchasing a property, demonstrating the intent to buy a home. Earnest money also gives the buyer more time to secure financing and funding, conduct a title search, and have the property valued and inspected before closing. Thus, in many ways, earnest money definition can be considered a good faith deposit, a down payment on a home, or an escrow deposit.

Why Is Making An Earnest Money Deposit Important?

Although earnest money is not required to be part of a home offer by law, it’s a standard practice in most real estate transactions in the US. In most cases, sellers will ask for a good faith deposit before accepting a purchase contract as it safeguards the interests of both the seller and the buyer and acts as “added” insurance for both parties.

Earnest money acts as “goodwill money” to show the seller that the potential buyer is serious about purchasing the home, which can be reassuring in the case of taking the house off the market while awaiting the appraisal and inspection results. It decreases the likelihood of a buyer placing multiple offers and protects the seller in case the buyer backs out of the agreement.

On the other hand, the buyer can have peace of mind knowing that if the deal fell through due to failed contingencies listed in the contract, they would get their earnest deposit back. When buying properties with high demand, a substantial earnest money deposit can also drive the seller to select your offer over others, help you get more favorable contract terms, and lower the amount you need at closing since it's applied directly to your down payment or closing costs.

How Much Earnest Money Does a Homebuyer Need to Pay?

The amount of earnest money is negotiable and mainly varies depending on the local real estate market but typically falls somewhere between 1% and 2% of the purchase price. A lower earnest money deposit may be suitable for a fixer-upper in a slow market, while in competitive, hot markets with multiple buyers, sellers are more likely to expect higher earnest money amounts that might range between 5% and 10% of the sales price.

How the “Good Faith Deposit” Works

After the seller accepts an offer, both the seller and buyer sign a real estate contract that defines the conditions of refunding the earnest money. The buyer delivers the earnest money deposit amount when entering into the purchase agreement, and the seller takes the home off the market until the sale successfully closes.

Earnest money is usually held on an escrow account or a third-party trust like a legal firm, real estate broker, or title company until the sale is wrapped up.

What Happens to Earnest Money at Closing?

The sale is only finalized when all the criteria covered by the contingencies listed in the purchase agreement are met. They typically include (but aren’t limited to) inspection, appraisal, and mortgage approval, among other items.

The earnest money deposit funds remain in the trust or escrow account until closing when they get applied to the buyer's down payment or closing costs or forfeited to the seller in case the buyer fails to follow through on their end of the bargain.

Who Keeps Earnest Money?

Depending on how the deal goes through, one of the following scenarios can happen:

• If the deal goes smoothly and the buyer proceeds with the home purchase, the earnest money is put towards the buyer's down payment and closing costs.
• If the seller terminates the deal for any reason not listed in the contingencies or 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 covered by the contract, the buyer forfeits the earnest money, which then goes to the seller.

Is Earnest Money Refundable?

One of the most common questions about this good faith deposit is: “Can I get my earnest money back?” Earnest money is refundable under certain conditions, depending on the contingencies in the contract that allow the buyer to recoup their deposit.

The buyer always gets an earnest money refund if something goes wrong, such as an appraisal turning out to be lower than the sale price or a significant flaw with the house has been discovered during the inspection. If the seller terminates the deal without a valid reason or over contingencies not listed in the contract, the buyer gets their earnest money deposit back.

However, the earnest money isn't always refundable. The seller gets to keep the earnest money if the buyer has a change of heart and decides not to go through with the home purchase for contingencies not listed in the contract or fails to meet any of them.

Protect Your Earnest Money with the right Escrow Services

The real estate market isn't immune to fraud and buying a home is a big purchase you shouldn’t bargain with. To prevent forfeiture and ensure the earnest money deposit is handled adequately, you need a reputable escrow company like Lightspeed Escrow in your corner to safely hold the earnest money until closing, protect both parties in the transaction and ensure they abide by the sales contract.