Today’s red-hot housing market is challenging for many buyers to navigate. Rising interest rates, bidding wars and low housing supply can make purchasing a home more strenuous than usual.
However, one way that buyers can stand out is with a sizable earnest money deposit. Earnest money is a cash deposit a buyer makes when they make the seller an offer that provides security to the seller that you’re making a good faith effort to buy the property. Working with a financial advisor can give you a clearer financial picture that will enable you to know how much earnest money you can afford to put down on a competitive property.
What Is Earnest Money?
Earnest money is a deposit that a potential buyer puts down to validate their offer on a real estate property. When buyers are interested in a home, they almost always put down earnest money to demonstrate they are committed to purchasing the property. Earnest money separates people just browsing from buyers ready to make a transaction. An earnest money deposit is also known as a good faith deposit.
Your earnest money goes into an escrow account, where it sits until you close on the home or walk away from the deal because of alarming inspection results or other contingencies in your purchase contract. If you decide against buying the home for a valid reason, you get your earnest money back. If you end up purchasing the property then your earnest money will go toward your down payment.
However, you might not get your earnest money back if you decide to back out for a less severe reason. For example, if you put an offer on a house and the seller pulls it off the market to accept your offer, you have entered a purchasing contract with the seller. If you find another house you like more and back out of the first deal, or just don’t close fast enough, your earnest money will go to the seller. In other words, earnest money protects the seller’s interest if the deal falls through for a reason other than a contingency in the contract.
How Much Earnest Money Is Enough?
Earnest money shows the seller you’re interested enough in their home to back your offer with cash. By having skin in the game, you can convince the homeowner to pull their home off the market and sell it to you. Additionally, a hefty good faith deposit can separate you from the pack and give you the edge in a competitive real estate market.
The typical earnest money provided is 1-3% of the purchase price. In a seller’s market, larger earnest money deposits can be necessary to compete with other buyers. However, it’s best to understand the dynamics of your local market before making a good faith deposit since you may live in a pocket with less competition.
Or, the property you’re looking at might be in its sixth month on the market and recently dropped its price. In that case, the seller might accept less generous offers.
Your real estate agent should be able to guide you on how big you should make your good faith deposit. While throwing your money around on homes you’re unsure about is unwise, putting down robust earnest money on your dream home can help you in a hot market.
Can I Get My Earnest Money Back?
You can get your earnest money back if one of the contingencies you set in the purchase contract is violated. For example, if your lender does not approve your mortgage or the home inspection reveals a significant flaw in the home, you will get your earnest money back if the contract contains this contingency.
However, your earnest money will go to the seller if you walk away from the deal for a reason not stated in the contract. While losing earnest money is a challenging situation for the buyer, the seller also takes a risk by taking their home off the market and spending time with a specific buyer.
Reasons Why You Can Lose Your Earnest Money
You might lose your earnest money in the following two situations:
- Canceling without contingencies: In a seller’s market, buyers sometimes make offers with no contingencies in the contract to differentiate themselves from other buyers. However, if the buyer discovers an immense issue through the home inspection and decides not to buy the home, they will lose their good faith deposit.
- Not closing on time: Usually, a home sale contract contains a timeframe that a buyer must close within. However, if the buyer takes too long to close, they might violate the contract, losing their earnest money and the ability to purchase the home.
Steps to Protecting Your Earnest Money
Your earnest money is an investment in the home you want to purchase, however you can’t realize that investment if you end up walking away from your offer to buy the home. As noted above, you could end up losing the money and it could damage your ability to put offers in on new homes in the future. Here are four ways you can protect your earnest money:
- Deposit Your Money in an Escrow Account Unfortunately, every industry experiences dishonesty and theft from time to time. Therefore, it’s risky to place your earnest money with the seller or real estate company. A safer alternative is the title company you intend to use for closing. The title company will hold your money and are far less likely to drag their feet in returning the funds than a seller who feels burned if the sale falls through. In addition, you can use a wire transfer, personal check or certified check to make your good faith deposit and keep a receipt from the transaction.
- Spell Out Your Contingencies Before you make an offer, discuss the contingencies you want with your real estate agent. That way, you can go into the deal entirely aware of the valid reasons you can pull out of the deal and get your earnest money back. Keep in mind that the more contingencies you have, the less appealing your offer might become to the seller. Many agents might suggest increasing the amount of earnest money if you have too many contingencies.
- Don’t Procrastinate During Closing Most contracts state how long you have to close after the seller accepts your offer. As a result, it’s a good idea to stay on top of the requirements to close. For example, approval for financing, the home inspection and appraisal must occur before closing day. Taking care of your obligations efficiently can help you close in time.
- Put Everything in Writing Stating every detail and contingency plainly in your contract can help you avoid sticky situations and conflicts with the seller. Whether you’re waiving certain contingencies or want specific concessions from the seller for the sale to go through, it’s recommended to ensure everything is in writing. If you assume everyone is on the same page without explicit language in your contract, you could be in danger of losing your earnest money if one of your expectations isn’t met, but the contract is vague.
The Bottom Line
Earnest money can be an effective tool for buyers who want to avoid bidding wars and stand out in a hot housing market. However, you also risk losing your earnest money if you enter a purchase agreement without contingencies or fail to close in time.
Your good faith deposit is a way you can put your hard-earned cash to work to secure the home of your dreams. As such, it’s crucial to protect that money through a contract with specific contingencies describing when the buyer or seller receives earnest money if the deal falls through.
Tips for Using Earnest Money Effectively
Tips for Using Earnest Money Effectively
- Knowing what kind of mortgage fits your financial plan will help you secure financing without difficulties, which means one less obstacle for closing. A qualified financial advisor can help you construct a financial plan and set goals. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Your earnest money shows the seller you’re serious about buying their home. As a result, an impressive good faith deposit could help you persuade the seller to work with you and bypass a stressful, costly bidding war.
- The housing and mortgage market has been volatile in recent years. Don’t go in blind – use SmartAsset’s mortgage rates table. With it, you’ll better understand the market’s climate.
