If you’ve considered buying a home recently, then you probably know how hot the market has been. While rising interest rates may cool the market a bit, a combination of strong demand and limited supply will likely continue this period, which is one of the most competitive housing markets in recent history.
While that’s great for sellers, who have been able to command higher prices, it’s proven to be a challenge for many buyers. After all, when demand is so high and there’s no lack of prospective buyers for a seller to consider, how are you supposed to stand out?
The good news is that there are ways that you can make yourself a more appealing buyer when you make an offer on a home. One such way is by putting up what’s known as earnest money.
Below, we define earnest money, explore how it factors into the homebuying process, and answer some of the most common questions that people tend to ask.
What is earnest money?
You’re probably aware you’ll be required to make a down payment when you actually purchase your home. Earnest money, while not always required, is a deposit you can put down when you make an offer to purchase a home. It shows a seller that you’re serious about buying their house. For this reason, earnest money is also sometimes called a good-faith deposit. Usually, an earnest money deposit will be between 1 and 3 percent of the final sale price of the home.
What does earnest money go toward?
In a typical home buying process, when you make an offer on a house and the seller accepts your offer, the house is taken off the market. But that doesn’t mean that the sale will ultimately proceed all the way to closing. If you, as the buyer, choose to back out of the deal, then the seller will need to relist their house and essentially start the process from scratch, which can be both emotionally and financially taxing.
While putting up earnest money does not mean you’re committing yourself 100 percent to buying the home, it does show the seller that you’re serious about your intention. This reduces their risk and makes them more likely to want to work with you.
If the deal closes, the earnest money will be applied to the purchase. If the deal falls through because of any contingencies listed in the contract (which we’ll discuss below), then you’ll get the earnest money back. But if you change your mind and back out of the deal, then you’ll forfeit the earnest money to the seller.
How to protect yourself
If you’d like to include earnest money as a part of your offer to buy a house, it’s important to take the following steps to protect yourself:
1. Read the terms and conditions of the contract
Before signing the contract, you need to make sure that you’ve read it in full and understand all of the terms and conditions. Otherwise, you may find yourself agreeing to something that puts your earnest money at risk. If you’re in doubt, it’s good idea to hire a lawyer who can help you understand the contract and inform you of any risks.
Pay special attention to key dates and ensure that any necessary actions are taken by those dates.
2. Ensure all necessary contingencies are included
Just because you’ve made an offer on a house doesn’t mean you’re obligated to purchase it — even if your offer includes earnest money. The deal will only close once certain criteria, also known as contingencies, are met. With this in mind, it’s important to ensure that your contract includes any contingencies which might prevent you from wanting to (or being able to) purchase the home.
Some of the most common contingencies include:
Financing: Unless you were preapproved for your mortgage, you’ll need to be approved before your deal can officially close. In the event that you are not approved and must back out of the deal, a financing contingency will help you avoid losing your earnest money deposit.
Appraisal: Typically, you will make an offer on a house before you’ve had it appraised. This means that you don’t know if the house is actually worth what the seller is asking for it. An appraisal contingency gives you the opportunity to back out of the deal if the appraisal comes back showing that the house is not actually worth what the sellers are asking for.
Home Inspection: The home inspection is your opportunity to evaluate the house on a structural level so that you’ll have a better sense of whether or not the house is safe and whether or not there is any damage in need of repair. A home inspection contingency allows you to back out of the deal in the event that the home inspection shows damage that you were not expecting or that you would consider to be a deal breaker.
Selling an Existing Home: If you’re in the process of selling your current home while shopping for a new one, this contingency allows you the opportunity to back out in the event that your current home doesn’t sell.
3. Place your earnest money in escrow
Do not give your earnest money directly to the seller. If you do, you may find it a lot harder to reclaim if you were to back out of the deal — even if it’s entirely within your rights to do so. Instead, it’s a good idea to place the earnest money funds in escrow with a third party until closing.
Earnest money FAQs
How much earnest money is enough?
The average amount of earnest money typically falls between 1 and 3 percent of the home’s final purchase price. But in especially competitive markets, it is not uncommon to for those percentages to be higher.
Is earnest money the same as a down payment?
No. Earnest money is essentially a deposit to show a buyer that you are serious about your offer. A down payment is a certain percentage of the home’s purchase price that you pay when you’re closing the deal.
But once the deal is finalized, you can apply your earnest money deposit to your down payment.
Is earnest money always required?
No. While a seller can require earnest money to move forward with an offer, they don’t have to. Either way, earnest money can help you stand out from other buyers.
Other financial considerations when buying a home
Buying a home is a exciting and tops many people’s lists of biggest financial goals. When you’re getting ready to make a major purchase like a home, it can be a good idea to step back and look at your larger financial picture.
A financial advisor can help you evaluate your situation and help you to feel more confident about your decision.