Earnest Money Deposit - The Buyer's Good-Faith Gesture

Editor's note: We get a lot of questions from home buyers about the earnest money deposit when buying a home. How much money do I need to put down? What happens to the money when the offer is accepted? Will I get it back if I back out of the deal? Under what circumstances can the seller keep it? You'll find answers to these and other earnest money questions below.

Here are some of the more frequently asked questions we have received over the years:

What is earnest money?

When you make an offer to buy a house, you want the seller to take your offer seriously. So you offer a "good faith" deposit toward the purchase price. This is also referred to as the earnest money deposit. You are using this money to show the seller you are earnest (an old-fashioned word for serious) about buying their house.

Don't confuse this with the down payment on the house. They are two separate things, though both can be applied toward the purchase price.

If the seller accepts your offer and the deal goes through, the earnest money will be go toward the purchase of the house. So it becomes part of your investment in the property. If you back out of the deal, however, you could wind up forfeiting the earnest money to the seller. We will talk more about these scenarios below.

It's more of a real estate tradition than anything else. But it does send a signal about you as the buyer. It says you're not trying to waste anyone's time, and that you are seriously interested in the property. You may hear this referred to as the deposit, the good-faith money, or the earnest money. These terms are used interchangeably, but they all mean the same thing.

When do I pay it?

In most cases, you would pay the earnest money when making an offer to buy a house. In fact, the exact amount should be spelled out in the contract. When I say "contract" in this context, I am referring to the purchase agreement that you write up. Your real estate agent should help you prepare this document.

The purchase agreement will include the amount you are offering to pay for the house, as well as the amount of earnest money you are paying. The purchase agreement should also include certain contingencies that allow you to back out of the deal. We will talk more about contingencies below.

How much should I pay?

Earnest money deposits usually range between 1% and 3% of the purchase price. Here in California where I am, most home buyers put down 3% for earnest money. It varies from one real estate market to the next.

In some markets, the standard amount might be $500 to $1,000 -- regardless of the purchase price being offered.

There are no laws governing this, by the way. It's more a matter of local custom and tradition. Your real estate agent is your best resource in this area. He or she can tell you how much earnest money you should pay when making your offer.

When my wife and I were selling our house in Texas, we had a buyer who put down $500 in earnest money. We were also in a situation where we had multiple offers from buyers. We were selling the house for about $275,000, so the $500 deposit wasn't even equal to 1% of the purchase price. This told us that these particular buyers weren't very "earnest" about buying our house.

The other offers included earnest money in the 1% - 2% range. It seemed to us that the buyers with the lower deposit amount were trying to hedge their bet, because they felt they might back out of the deal. This worried us and made us less inclined to accept their offer. And that's exactly what happened. We accepted a stronger offer, and that was the last we heard of the low-ball earnest money people.

See also: How much should I offer for a house?

My advice is to follow the local custom when making your earnest money payment. Offer the average amount -- no more and no less. That way, you won't risk insulting the sellers. Nor will you have an unusually large amount of money on the line if you back out of the deal.

When does the buyer get the earnest money back?

There are two scenarios where you could get your earnest money back. The first scenario is if the seller rejects your offer. If you make an offer to buy a house and the seller turns it down, they are required to give you the earnest money back. This should be clearly stated in the purchase agreement.

It only makes sense, when you think about it. You are offering this money as a good-faith deposit toward the purchase of the home. But if the seller rejects your offer outright, they have no business keeping your earnest money.

The second scenario where the buyer can get the earnest money back has to do with contingencies. I talked about contingencies earlier, when I was describing the components of a standard purchase agreement. When you make an offer to buy a house, the offer should be contingent upon certain things.

The home inspection is a good example. You should have something in your purchase agreement that says if the home inspector uncovers a serious flaw that you are unwilling to accept, you can back out of the deal and keep your earnest money. Similarly, if the seller refuses to repair something on the home inspector's list, you should be able to back out.

When can the seller keep the deposit?

If you back out of the contract for no good reason, you could forfeit your earnest money. This is why contingencies are so important in a real estate purchase agreement. If you change your mind after the offer has been accepted, it's going to come down to the contingencies you've included in the contract.

If you simply had a change of heart, the seller will probably be able to keep the earnest money payment. Again, all of this should be clearly expressed within the purchase contract. Review this document with your real estate agent, and make sure you understand how the contingencies work before submitting the offer.

Who holds onto the money when the offer is made?

Normally, the buyer gives the earnest money payment to an escrow or title company. The escrow agent will act as a middleman between the buyer and seller. This neutral third party is responsible for closing the deal and ensuring all funds are distributed properly. In rare cases, the earnest money is paid directly to the seller (not recommended).

In closing, I would like to stress that the earnest money part of this process is mostly standardized. You shouldn't spend a lot of time analyzing this. Just ask your agent what a standard deposit amount is for your area, and pay that amount when you make your offer.

If you pay a lot less than the average good-faith payment, you risk having your offer rejected. If you pay a lot more than the standard amount, you risk losing more money if you back out of the contract. It's simply a check in the box that's needed to show the seller you are serious. So just pay the standard amount, include the appropriate contingencies in your offer, and move on with the process.

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