What is earnest money? How much is earnest deposit money? How does earnest money work? What’s the difference between earnest money and down payment funds?
These are all common questions that home buyers ask real estate agents daily.
By the end of the reading, you will have a solid understanding of the answers to these questions.
Many terms and concepts in real estate transactions can prove confusing or complicated, especially when you have never encountered them.
Earnest money is more complicated than confusing for most people since the term describes what it is – money the buyer gives to show they are heartfelt in their intention to purchase a home.
Although the term is easy to understand, the practice can become complicated, mainly if the deal falls through.
Both buyers and sellers need to understand the ins and outs of earnest money. From my experience working as a real estate agent for the past thirty-eight years, I know it is an integral topic to a successful transaction.
Three other terms used in place of earnest money are a house deposit, an escrow deposit, EMD, or good faith monies.
Homebuyers should never confuse the difference between these funds and a down payment.
We will look at everything you need to know about earnest deposit money.
What is Earnest Money?
The definition and purpose of earnest money are relatively easy to understand.
Earnest deposit money refers to a sum that a buyer provides to demonstrate their seriousness and commitment to purchasing a property in the real estate market. It is typically paid upfront when the buyer submits an offer on a property.
The purpose is to protect the seller from potential buyers who may not follow through with the purchase, as it demonstrates the buyer’s intention to proceed with the transaction.
It provides financial assurance to a home seller that the buyer will move forward and protects them legally if they don’t.
The funds are typically applied toward the buyer’s closing costs or down payment if the sale is completed. However, suppose the buyer fails to fulfill their obligations under the contract.
In that case, the buyer’s deposit may be forfeited to the seller as compensation for their time and the potential loss of other interested buyers.
The funds can be delivered to the brokerage office. They will issue a receipt. In cases where buyers are out of the area, they can set up a wire transfer.
The Steps in a Home Purchase Will Begin
When a buyer makes an offer on a home, the buyer and seller will enter into an agreement that pulls the property off the market so that the following stages of the sales process can happen – like the home inspection and home appraisal.
However, the agreement does not require the buyer to purchase the home, at least not yet.
That wouldn’t work since guaranteeing you will buy a property before it is inspected or appraised is a recipe for disaster.
The seller needs some motivation to take the home off the market because they lose out on any other offers that might come through.
After all, even if the inspection and appraisal go well, the buyer’s mortgage commitment could fall through.
With an earnest money deposit, the buyer shows the seller they are committed to buying the home. The payments protect the seller so that a buyer cannot just walk from a sale on a whim.
The last thing a seller wants is to feel uneasy that a buyer might be out looking for something better.
Facts Buyers and Sellers Should Know
1. Earnest money is a form of deposit made by a buyer to show their serious intent to purchase a property.
2. It is typically a percentage of the property’s purchase price, often around 1-5%.
3. It is used as a safeguard for sellers, protecting them financially if the buyer backs out of the transaction without valid reasons.
4. In real estate transactions, the money is usually held by a third party, such as an escrow company, title company, or real estate brokerage.
5. If the sale goes through, the money is typically applied toward the buyer’s down payment or closing costs.
6. However, if the buyer fails to fulfill their obligations under the purchase agreement, they may forfeit their funds.
7. The amount required can vary depending on local customs and market conditions.
8. Earnest deposits help to deter speculative buyers and demonstrate sincerity from prospective buyers.
9. If both parties agree, contingencies may allow the buyer to retrieve their deposit money if specific conditions are unmet (e.g., the property fails inspection or appraisal).
10. Deposit money is most commonly associated with real estate transactions, but it can also be used when a financial commitment is needed to demonstrate good faith.
An EMD is Insurance in Case a Buyer Defaults
The seller would be compensated with escrow funds if the buyer decided not to purchase without a legitimate reason outlined in the real estate contract. Another way to think of these escrow funds is insurance if a buyer defaults.
Just how serious the proof shown by the EMD needs to be depends on the market. Deposit amounts tend to increase in markets where homes sell like hotcakes.
It is also essential to note that the seller is limited to collecting earnest money as liquidated damages in many locations. In other words, they can’t sue the buyer for more money for their lack of performance.
The language in purchase and sale agreements will often look something like this:
If the buyer doesn’t fulfill the buyer’s agreements, the seller shall retain all deposits made hereunder as liquidated damages. This shall be the seller’s sole remedy at law and in equity.
How Do The Earnest Funds Work?
A refund will not be given if a buyer violates the contract terms.
The most apparent reason buyers would lose their deposit is if they back out of the contract for contingencies not listed.
If the buyer decides not to buy the home for any reason not listed in the contract, they will probably lose their deposit, even if the cause is legitimate, like a significant home defect.
Other common reasons for losing deposits include:
Buyer Fails to Meet Timelines in The Contract
The contract will have a deadline that must be adhered to by the buyer.
If the buyer fails to comply with the timetable – such as if they cannot get their loan funded by the due date – then if they break the contract and don’t buy the home, they will lose their deposit.
The Buyer Changes Their Mind
If the buyer has a change of heart and does not buy the home, they can lose their money.
Sometimes, buyers decide not to buy a home after entering a purchase agreement.
If this happens and the buyer cannot link the decision to pass on the purchase to a contingency listed in the contract – like if the buyer decides they don’t like the home anymore – then walking away from the sale will result in the forfeit of the deposit to the seller.
These are the instances when sellers can keep the earnest money. There are times when houses go back on the market.
Where is The Money Held?
In most real estate transactions, the listing brokerage or the seller’s real estate attorney will hold the buyer’s money. Sometimes, this deposit is stored in interest-bearing accounts; other times, it is not.
It really will depend on local customs.
When the earnest funds are deposited, they go into an escrow account until the sale closes. Then, the money is applied to the buyer’s purchase price for the property.
Sometimes, earnest deposit payments are divided into two phases. This happens because, in some states, there are two contracts – the offer to purchase and the purchase and sale.
For example, in Massachusetts, where I’m located, we are a two-contract state.
If the payment is broken in two, the first payment will usually be between $500 and $5,000. The second payment will be the remainder of the agreed-upon deposit amount.
How Much is a Buyer’s Deposit?
One of the most common questions from potential buyers is how much earnest money is in real estate.
There is no hard-and-fast rule regarding the amount of money a buyer needs to pay a seller, but there are typical ranges seen in most home sales.
Earnest deposits usually range between 1% and 5% of the home’s purchase price. However, if the housing market is hot, the escrow funds may shoot up to 5% and 10% of the home’s purchase price!
Buyers may use a higher earnest money offer to sway sellers to sell them a home they want in a high-demand area. This is one tactic buyers will use to win a bidding war, along with possibly an escalation clause. It could give them an edge over the competition.
It is a strategy many brokers will recommend, especially in a seller’s market.
Buyers should talk to their real estate agents about what the expectations are in their market once they start house hunting because there is a big difference between 1 and 10 percent.
One percent of a $300,000 home would be $3,000, while 10% would be $30,000.
It is worth remembering that most sellers do not consider buyer deposits as crucial as how fast you can close and how much down payment you will make on the purchase.
Buyers should always consult with their Realtors to determine the best mix of terms to purchase a home they are interested in.
Deposits Are Higher With New Construction
It should be noted that earnest money deposits are usually ten percent of the purchase price when buying a new home.
Sometimes, a builder will use these funds not held in escrow like a traditional resale home. You should consult an attorney before allowing a builder to keep your funds.
Many builders went out of business during the real estate bust, and buyers lost their deposit funds — an excruciating lesson.
What’s the Difference Between an EMD and a Down Payment?
Buyers are often confused about the difference between the earnest money they put in escrow and the deposit toward their down payment. Although the funds come from the buyer’s pocket, they serve different purposes.
As mentioned, it is considered a good-faith deposit that shows the buyer is serious about purchasing the home.
A down payment should not be confused with earnest money.
What is a Down Payment?
On the other hand, a down payment is funds that a buyer pays directly to a seller at the closing.
People commonly misunderstand that the money will go to the lender when considering down payments. This is false.
The lender will want to know you have a down payment, but they don’t get these funds.
The home’s purchase price balance comes from the mortgage you receive from a lender.
The money a buyer puts down on the house can come from several places, including personal savings, the sale of a prior home, or gift monies from a family member.
A certified cashier’s check brought to the closing is required for down payments.
It’s also possible for a buyer to choose to have funds wired directly from their bank.
Does The Money Go Towards a Down Payment?
Yes, it can. For example, buying a $400,000 home with ten percent down would equal $40,000.
If you put five percent up for earnest money, you would need to come up with an additional five percent to have ten percent down.
Down Payments Can Depend on Mortgage Programs
The amount of down payment you choose depends on the mortgage program you will use.
There are numerous mortgage programs for first-time buyers. Some of the most popular include:
- Conventional loans – the lowest down payment on a conventional loan is 3 percent. It used to be 5 percent.
- FHA loans – the lowest down payment for FHA mortgages is 3.5 percent.
- VA loans – if you are in the military or a veteran, you can get a loan with no money down. There are other requirements, but there are benefits to a VA mortgage.
- USDA loans – USDA mortgages are considered rural loans. If you live in a rural area, you can also use USDA financing and put zero down.
A twenty Percent Down Payment is Not Expected
For many years, a twenty percent down payment was the holy grail of mortgage lending. That is no longer the case; it hasn’t been in quite a while. It is a significant mortgage myth.
The average down payment on a house is around 6 percent for first-time buyers and 11 percent for owners who have owned homes.
Right or wrong; however, many sellers and their agents will look more favorably towards buyers who have larger down payments.
There is also a significant advantage to buyers who put at least twenty percent down – they avoid paying what’s known as private mortgage insurance, which can be expensive. It is a useless fee that protects lenders in mortgage default.
Most buyers will want to stop paying private mortgage insurance immediately.
When is a Refund Given to Home Buyers?
What causes the EMD to be returned to the buyer?
The home purchase contract specifies situations where good faith funds can be refunded. Although many conditions can be identified, only a few are usually included.
These are the common reasons for an earnest money deposit refund:
The Home Does Not Appraise For The Sales Price
A home appraisal can be a significant hurdle to selling a home. Buyers are not keen to pay more for a house than it is worth, and mortgage lenders can deny funding when there is an appraisal gap.
Lenders are not interested in purchasing homes for more than they are valued because they will have trouble getting their money back through a sale if the borrower defaults on the loan.
Occasionally, there are errors on an appraiser’s part that could warrant appealing a low appraisal.
The Home Inspection Uncovers Significant Problems
The number one way a buyer will have their deposit money refunded is due to inspection issues. A home inspection contingency is a standard part of most real estate contracts.
A home inspection is the other big hurdle for sellers to overcome. Most home inspections will find flaws, but those defects are usually minor enough to be repaired or accepted by the buyer eager to get the home.
However, if the home inspection problem is significant enough – like a structural problem with the foundation – the cost of repairs will be prohibitive.
After discovering a substantial flaw, selling the home at its current price may not be possible. Unexpected issues can be expected when buying a fixer-upper home. Inspections should not be waived if at all possible.
The Buyer Cannot Get a Mortgage Commitment
Sometimes, buyers cannot get financing and have their earnest deposit money refunded.
A mortgage contingency clause is included in most real estate contracts. The financing contingency specifies the amount of money the buyer wants to mortgage, the date they must apply for the loan, and when they will receive a mortgage commitment.
If the buyer is rejected for financing, they will get their money back as long as they notify the seller in writing before the expiration of their mortgage contingency.
Sometimes, some circumstances cause homebuyers not to get a mortgage commitment. For example, if they take on significant debt by running up their credit cards or if interest rates skyrocket.
These things could cause a buyer’s credit score to drop or their debt-to-income ratio to increase. The best advice is to avoid any significant spending before closing. Borrowers can screw up their credit which can damage their ability to get a loan.
All these are factors in getting a home loan unless you pay cash.
When buyers do not inform the sellers in writing before the clause expires, they can lose their funds.
Home Sale Contingency
As part of the negotiation, a home seller occasionally will accept a home sale contingency. It is a significant risk and, because of that, is often not acceptable.
Title Problems
A standard part of most real estate contracts is delivering a clear title to a home buyer. A title company will perform a title search to check for any title defects. If a problem is discovered, the seller will assume the costs to rectify the issue.
In these cases, the buyer can terminate the sale if the problem is not rectified. A seller typically has a specified amount of time to solve the problem.
What Causes The Buyer to Lose Their Deposit?
Buyers always ask real estate agents if the earnest money is refundable. A refund will not be given if a buyer violates the contract terms.
The most apparent reason buyers would lose their deposit is if they back out of the contract for contingencies not listed.
Suppose the buyer decides not to buy the home for any reason not listed in the contract. The buyer will probably lose their deposit even if the cause is legitimate, like a significant home defect.
Other common reasons for losing deposits include:
Buyer Fails to Meet Timelines in The Contract
The contract will have a deadline that must be adhered to by the buyer.
If the buyer fails to comply with the timetable – such as if they cannot get their loan funded by the due date – then if they break the contract and don’t buy the home, they will lose their deposit.
The Buyer Changes Their Mind
If the buyer has a change of heart and does not buy the home, they can lose their money.
Sometimes, buyers decide not to buy a home after entering a purchase agreement.
If this happens and the buyer cannot link the decision to pass on the purchase to a contingency listed in the contract – like if the buyer decides they don’t like the home anymore – then walking away from the sale will result in the forfeit of the deposit to the seller.
These are the instances when sellers can keep the earnest money. There are times when houses go back on the market.
Ways Buyers Make Mistakes
Making mistakes when buying a home for the first time is effortless without proper guidance.
This can happen when you don’t have a skilled buyer’s agent in your corner.
Here are some of the most common EMD mistakes you’ll want to avoid:
Not Having Giving Enough Money
In a hot seller’s real estate market, you must include at least the standard escrow amount in your offer. Otherwise, you’ll be disadvantaged if other offers are on the table.
Not Giving a Security Deposit Because You’re Using a VA or USDA Mortgage
Over my thirty-eight years, many buyers have missed out on homes because they are unwilling to invest in the transaction.
Just because you get a no-down payment loan doesn’t mean you should have no earnest money.
Put yourself in the seller’s shoes.
Removing Contingencies, You Shouldn’t
On the other hand, some buyers will waive standard contingencies such as a home inspection or financing to strengthen their offer.
Be sure you don’t make the kind of blunder you’ll regret.
Letting Your Contingencies Expire Without Responding
In real estate contracts, some timelines need to be met. As a buyer, you lose that contingency if you don’t meet them. Make sure you pay careful attention to all deadlines.
Fighting About Money, You’re Not Entitled to
At times, buyers make costly mistakes and compound them by spending more time and energy trying to contest something there is no chance of winning.
If you back out of a sale a week before closing because you changed your mind, let the deposit go. Sellers must also understand that they can’t keep a buyer’s funds if they have followed the contract terms.
What Happens to The Deposits at Closing?
A buyer’s funds are duly accounted for at the closing. Your deposit goes toward the purchase price.
For example, if you purchase a $600,000 home with $30,000 in escrow, the remaining funds would come from your down payment and mortgage.
Avoid Disputes
The last part of my guide discusses what happens if the release of an escrow deposit is contested.
When a real estate transaction falls apart, it is common for the buyer and seller to dispute who gets the deposits.
Many standard real estate contracts have language like the following:
“All purchase deposits made shall be held in escrow by an escrow agent subject to the terms of this agreement and shall be duly accounted for at the time of the performance of this agreement.”
Suppose there is any disagreement between the parties. In that case, the escrow agent shall retain all deposits made under this agreement pending instructions mutually given in writing by the seller and the buyer.”
Suppose the dispute between the buyer and seller cannot be resolved. In that case, the escrow agent will continue to hold the home deposits until a court of competent jurisdiction decides how to distribute them.
This means the real estate company cannot arbitrarily release the escrow funds even if they believe one party is entitled to them.
Over the years, I’ve seen a few deposit disputes where things can get nasty because one of the parties believes the real estate company should release the funds – sorry, they can’t.
Under these circumstances, following the contract when purchasing a home is imperative. Unfortunately, the homebuyer cannot demand anything from the broker. All the funds must remain in the account until the situation is rectified.
Interesting Statistics
1. The average earnest money deposited in a home purchase is $12,750.
2. In urban areas, deposits tend to be higher, with an average of $15,500.
3. About 78% of homebuyers include a deposit of at least 1% of the total purchase price.
4. Studies show homes with higher deposits receive 14% more offers on average.
5. Roughly 40% of home sellers require deposits to be made within 48 hours of accepting an offer.
6. In competitive markets, the percentage of homes requiring non-refundable money is approximately 21%.
7. Over the past five years, the median percentage return on earnest money investments has been 4.2%.
8. According to industry data, disputes comprise only 3% of real estate legal conflicts.
9. On average, it takes 27 days for a buyer to receive their deposit back after canceling a contract.
Final thoughts on EMD
Hopefully, you now have a much better understanding of earnest money in real estate. These deposits are essential to keep a real estate transaction together.
They are similar but different from down payments. If you are still unclear about how this works, contact me.
About the Author: Bill Gassett, a nationally recognized leader in his field, provided the above real estate information on what earnest money is and how it works. He is an expert in mortgages, financing, moving, home improvement, and general real estate.
Learn more about Bill Gassett and the publications he has been featured in. Bill can be reached via email at billgassett@remaxexec.com or by phone at 508-625-0191. Bill has helped people move in and out of Metrowest towns for the last 38+ years.
Are you thinking of selling your home? I am passionate about real estate and love sharing my marketing expertise!
I service Real Estate Sales in the following Metrowest MA towns: Ashland, Bellingham, Douglas, Framingham, Franklin, Grafton, Holliston, Hopkinton, Hopedale, Medway, Mendon, Milford, Millbury, Millville, Natick, Northborough, Northbridge, Shrewsbury, Southborough, Sutton, Wayland, Westborough, Whitinsville, Worcester, Upton, and Uxbridge MA.
Hi Bill,
Excellent article Bill and so very true as you will remember, I was able to keep my earnest money thanks to your advice.
Val (Daniels)
I sure do Val. Buyers often think that they can do whatever they want and have no consequences. Having earnest money has a purpose for sellers. Without a doubt buyers also confuse earnest money with a down payment.
Good Afternoon!
Thanks for the info. I am wondering how it works if you put earnest money down and make an offer on the home. Can the seller chose another offer? (I assume so) If so, do they keep your earnest money because THEY chose to move on to another offer? My friend is having that issue right now, and we’re wondering how to resolve the situation.
Thank you!
Natalie – a seller cannot keep your earnest money when you are not the winning bidder on a home. Your earnest money deposit needs to be returned to you right away.