What Is Earnest Money and How Does It Work?

How Earnest Money Works

Now that you know what earnest money is, here’s how it works:

1. Offer and agreement: When you make an offer to buy a house, you'll offer a certain amount of earnest money. The purchase agreement specifies the deadline to make the earnest money deposit after the contract is signed. It's usually a few days.
2. Third-party escrow account: If your purchase offer is accepted, you’ll deposit the earnest money in an escrow account. This account is managed by a neutral third party like a real estate attorney or title company. 
3. Property is off the market: The seller changes the status of the property to pending and stops marketing the home temporarily. The deposit will be held in escrow while contingencies (conditions of the sale) are met and you secure financing.

Can Earnest Money Be Refunded?

In certain cases, if you decide not to complete the sale, earnest money will be refunded. In other situations, it will not. You should fully understand all conditions that allow you a deposit refund before you sign your purchase agreement. The table shows when earnest money is and is not refunded. 

If the sale is completed, the earnest money will credited toward the closing costs or down payment at closing, and any amount exceeding the amount required will be returned.

Why Do You Need to Pay Earnest Money?

An earnest money deposit is critical to the homebuying process. Here are some reasons an earnest money deposit is important. 

• Show good faith: The purpose of earnest money is to show you are serious about making the purchase. In many cases, a large earnest money deposit can strengthen your offer. 
• Compensate the seller: If the seller accepts the offer, and you walk away from the sale for reasons other than those covered by contingencies (conditions) in the contract, the seller may be able to keep the earnest money deposit as compensation for keeping the home off the market. 
• Take the home off-market: When homeowners accept a bid, they take the home off the market until the sale closes. While they might still be able to show the home and receive backup offers, interested parties might steer clear of a home with a contingent or pending sale. 
• Reduce closing costs: The earnest money that borrowers put into escrow can be used to cover part of the down payment or closing costs. This means the buyer does not need to bring as much money to the table at closing. 

How Much Earnest Money Should You Put Down?

Earnest money deposits usually total around 1% to 3% (though sometimes up to 5%) of the purchase price. This means that if you want to buy a $300,000 house, you might need to make an earnest money payment between $3,000 and $15,000.

There is no hard-and-fast rule on how much your earnest money deposit should be. In a market where sellers may receive multiple offers on their houses, a higher deposit may help you make a stronger offer.

As long as the purchase agreement is written correctly with the right contingencies in place and it makes sense for the buyer’s cash flow, there’s no downside for a buyer to make a larger earnest money deposit, as it will typically go toward closing costs or be refunded. 

How to Protect Your Earnest Deposit

You are putting thousands of dollars on the line when you make an earnest money deposit. You need to protect this money, and you have multiple options for doing so. Here are some of the ways to protect your funds. 

• Send the funds only to a trusted escrow company: You'll usually do a wire transfer to move the money to an escrow account held by a title company or an attorney. Properly research to ensure you're sending your money to a legitimate company or individual, and confirm wiring instructions directly with your escrow company using a verified phone number before sending any funds.
• Include the right contingencies: You want to be able to walk away from the sale if something major goes wrong, like a serious problem revealed in inspection or the home appraising for much less than you offered. Including the right contingencies, like an appraisal contingency, title search contingency and financing contingency protect you if purchasing the home no longer makes sense. If you must sell your current home before you can close, you'd also want to include a home sale contingency.  
• Know the deadlines: Your purchase agreement may give you a limited time to satisfy each contingency. For example, if you don't have the appraisal or inspection completed in time, this could be viewed as waiving that condition. If you have an appraisal or inspection completed and the condition isn't satisfied, be sure to notify the seller right away.

Earnest Money FAQs

Still need to know more? Here are the answers to some frequently asked questions about earnest money.

Does Earnest Money Go Toward Your Down Payment or Closing Costs?

When the sale of a home closes, the third party that manages the escrow account credits the money back to go toward your down payment or closing costs, lowering how much you have to pay on closing day. If the escrow deposit amount exceeds what you owe at closing, you will be refunded. 

Who Keeps Earnest Money If a Deal Falls Through?

If a home sale falls through because a buyer contingency specified in the purchase agreement is not satisfied, then the buyer’s earnest money deposit is returned. If the buyer walks away from the sale without a justified reason, as specified in the contract, then the seller gets to keep the earnest money.

How Long Does It Take to Get Your Earnest Money Back?

An earnest money deposit is credited back to you at closing when the sale ends successfully. If you must cancel the sale for a valid reason and your deposit needs to be returned, then the timeline for it to be refunded can vary based on escrow company. It commonly takes between one and 10 days to get the money returned. 

Final Thoughts: The Purpose of Earnest Money

If you’re planning to buy a house, you should understand how much earnest money deposit fits your budget accordingly and contributes to a successful closing. A large deposit may make your offer more competitive, so be prepared to transfer the funds to escrow if your offer is accepted.

Sending your earnest money to escrow is just one of many steps you’ll need to take as you prepare to close on your home loan. Be sure to reach out to a loan specialist, such as Freedom Mortgage, early to explore your mortgage options. We will do everything possible to help you through the financing process, so your closing goes off without a hitch.