What is earnest money?
Earnest money is used by homebuyers to show the seller they’re serious about buying their home. It’s put down before closing and is also commonly referred to as a “good faith deposit” or “earnest money deposit.”
Once a homebuyer and a home seller move into the purchase agreement phase of the real estate transaction, the seller—or their realtor—takes the listing for the home off of the real estate market while the transaction goes through the journey to closing. If the deal falls through for any reason, the seller has the burden to re-list their home and start the process from scratch, often leading to a significant financial and logistical nightmare.
Earnest money is intended to protect the seller in the event the buyer backs out. It’s usually around one to three percent of the home’s sale price and is held in an escrow account until the sale is finalized. If the process progresses from start to finish, the buyer can apply the earnest money to their down payment or closing costs.
On the other hand, the buyer gets their earnest money back if the deal doesn’t make it to completion and falls through because of an unsatisfactory home inspection or other contract contingencies.
When a buyer decides to buy a home from a seller, both parties enter into a contract. But, this contract does not necessarily mandate the buyer to buy the home if there are contingencies because home inspection reports could later reveal issues with the house. What the contract does is ensuring the seller takes the house off the real estate market during the inspection and appraisal process and mark it as “Contingent” or “Pending”. The earnest money acts as collateral to make taking the house off the market worth it to the seller.
Earnest money case study
Irene, Grant, and Oliver are all selling their houses. Max and Molly are buyers in the market and have appointments to view all three homes. Molly loves Irene’s home and its open floor plan, but Max has always wanted a wood-burning fireplace like in Oliver’s house. Both Max and Molly like the fact that Grant’s house has a pool. Here is one example of what could happen:
- A forfeited deposit: The couple just can’t decide on a house. So, they make good faith deposits on all of them. As a result, Irene, Grant, and Oliver remove the listing for their homes from the market and let any other interested buyers know that someone is buying their house. A couple of days later, Max and Molly find out they’re pregnant. Now, they’re not so sure about the safety of having a pool with a little one and want Irene’s open floor plan for their growing family. So, Grant and Oliver have to put their homes back on the market and re-start the process from step one. But, the good news is that Grant and Oliver can keep the earnest deposits, which give Grant and Oliver some compensation for the time and money they lost when Max and Molly backed out of the sale.
The bottom line
If you’re a homebuyer, you may be turned off by earnest money because you think it’s just something else you have to pay for out of pocket. But, it’s an extremely important component of securing a real estate transaction from start to finish. It protects the seller if something is wrong with the transaction and ensures the seller that the buyer is serious about their offer.