Understanding Real Estate Terms: What is Earnest Money?

The home buying process can be a complicated ordeal, especially for the first-time homebuyer. There are stacks of paperwork to sign, dozens of financial forms to fill out, and the seemingly foreign language of real estate terminology to navigate. It can be confusing.

One of the terms you’ll hear is “earnest money.” What is it, why is it important, and how can you protect your initial investment? We’re here to explain it all.

What is Earnest Money?

You’ve searched and searched, and finally, you’ve found the perfect home. Now, it’s time to make an offer the sellers can’t refuse. Making an offer on a home is more complex than sending over a dollar amount; the offer contains important legal protections for both you and the seller and spells out any contingencies.

Your offer will also include the specific dollar amount you’ll provide as earnest money. But what is earnest money?

Earnest money is a good faith deposit, paid by check or money order, given to the sellers to prove you’re serious about buying their home. It’s a placeholder of sorts, ensuring the sellers remove the house from the market and allowing the buyer time for an inspection and an appraisal. If there are multiple offers on a property, you might consider offering a higher earnest money payment so the sellers will feel safe accepting your offer.

An earnest money payment is insurance of sorts for the seller: if the deal doesn’t go through, they get to keep the earnest money check (with some exceptions, mentioned below).

When is My Earnest Money Due?

You’ll pay the earnest money when you sign a contract with the sellers or shortly thereafter, so be sure you have cash on hand to make this payment. Earnest money amounts vary, but expect to pay 1%-2% of the home’s value. Depending on your location, typically, the listing office, title company, or attorney’s office will hold the deposit in escrow until closing, at which time it is applied to your down payment.

Is My Deposit Refundable?

Yes and no, depending on the reason the contract with the seller ended. Before entering into a contract with a seller, make sure you fully understand the terms of the agreement, including instances where you’ll get your earnest money back.

Typically, real estate contracts allow buyers a complete refund of their earnest money in the following instances:

• If the inspection reveals a serious problem. Most contracts allow buyers to back out of a deal if the home inspection reveals major issues like plumbing, electrical, termite damage, foundation concerns, or roof repairs. Buyers who cite concerns revealed during inspection almost always get a full refund of their earnest money payment.
• If the home doesn’t appraise. Lenders require an appraisal to make sure they aren’t lending more money than the home is worth. For instance, if you offered $350,000 for a home, but the appraisal comes back showing the property is only worth $285,000, the lender will refuse to issue a loan. In that instance, parties can renegotiate the deal to match the appraised price, or either party can choose to terminate the contract without consequence. In that case, the buyer will receive a full refund.
• Your financing falls through. Even though you’ve been pre-approved, nothing is final until closing day. It’s a scenario lenders see all too often: buyers get pre-approved, but then make less-than-stellar financial decisions before closing, and the entire deal comes crashing down. (Want to avoid being denied before closing? Check out our tips here.) In that instance, assuming you’ve met all your deadlines with the seller, you may still be entitled to get your earnest money back.

When is Earnest Money NOT Refundable?

Earnest money primarily protects the seller. Appraisal, inspection, and financing can take weeks. During that time, the sellers take their home off the market. Should the deal fall through, the sellers not only have to pay another month’s mortgage payment, but they’ve also lost out on weeks of potential showings and offers.

Earnest money is a small consolation that, should the deal fall through, they will have at least some financial compensation for the time lost.

You can expect to lose your earnest money in the following instances:

• You don’t meet deadlines. Failing to meet the deadlines established by your contract – such as inspection, appraisal, or financing deadlines – could terminate the agreement and cost you your deposit.
• Your contract doesn’t account for contingencies. Make sure you hire an experienced Realtor. Your contract should take into account all possible hiccups in the buying process. If the agreement doesn’t explicitly state that you get your earnest money back if the home doesn’t pass inspection, you could be out of luck.

Moving Forward to Closing

Once your offer is accepted, inspection passed, the home appraises, and your financing comes through, it’s onward to the closing table. Congratulations!