Earnest money: What is it and how much is enough?

In today’s housing market, making sure your offer on a home will stand out is important. There are a few ways to let a seller know you’re serious about buying a home, such as a preapproval from a lender, or the Rocket Mortgage^® Verified Approval program. Another option is putting down an earnest money deposit. 

This article will provide an overview of what earnest money is, how to use it to your advantage when buying a house and how to protect yourself once you deposit it.

What is earnest money in real estate?

Earnest money is put down before closing on a house to show you're serious about purchasing. It's also known as a good faith deposit.

When a buyer and seller enter into a purchase agreement, the seller takes the home off the market while the transaction moves through the entire process to closing. If the deal falls through, the seller has to relist the home and start all over again, which could result in a big financial hit. By requesting earnest money, the seller is protected if the buyer backs out.

How much do you need to pay in earnest money?

Earnest money is typically around 1% – 3% of the sale price and is held in an escrow account until the deal is complete. The exact amount depends on what's customary in your market.

What happens to earnest money at closing?

If all goes smoothly, the earnest money is applied to the buyer's down payment or closing costs.

If the deal falls through due to a failed home inspection or any other contingencies listed in the contract, the buyer gets their earnest money back. The practice of depositing earnest money can decrease the likelihood of a buyer placing offers for multiple homes, then walking away after the seller takes the home off the market.

Why should you pay earnest money?

Earnest money isn't always a requirement, but it could be a necessity if you're shopping in a competitive real estate market. Sellers tend to favor these good faith deposits because they want to ensure that the sale won't fall through. Earnest money can act as added insurance for both parties in the transaction.

Earnest money could also lower the amount you need at closing because it's applied directly to your down payment or closing costs. Essentially, you're just putting up some of the money earlier in the process.

How Verified Approval could help

Verified Approval from Rocket Mortgage can give you even more of a leg up on the competition by assuring the seller that you can qualify for the loan you need. A seller looking at multiple offers is more likely to lean toward a buyer with approved funding – and having earnest money down on top of it can make your offer stand out even more.

How much earnest money is enough?

The amount of earnest money may depend on the particular real estate market your desired property is in. A languishing real estate listing in a slow market may not need as much earnest money as in a hot market with multiple buyers who are vying for the same property. If you plan to purchase in a neighborhood where cash offers and bidding wars are common, a higher good faith deposit is a good idea.

If you're competing with others for the same property, it's in your best interest not to undercut the earnest money deposit amount because you could lose the home to a stronger offer. If it's a slow or moderate market, a good faith deposit in the standard range may suffice.

If you're working with a real estate agent, they should be able to provide direction on how much earnest money you should offer.

Is earnest money refundable?

Earnest money has contingencies that protect both the seller and buyer in certain situations.

When you make an offer on a home and the seller accepts, the sale is only finalized when contingencies, or certain criteria, are met. They're typically listed in the purchase agreement and cover the inspection, appraisal and mortgage approval, among other items.

Home inspection contingency

The home inspection is a common reason potential buyers back away from a deal. If your prospective home is inspected by a professional and some elements of the home come back in need of repair, a home inspection contingency can allow you to back out of the transaction.

If you don't want to back out of the deal, you could also work with the seller to have the repairs made or have them lower the purchase price so you can do the repairs yourself.

Appraisal contingency

The appraisal contingency, which protects the buyer if the property is overvalued, is equally important. The lender hires a third-party appraiser to determine the fair market value of the home and to compare it to similar properties for sale.

With this contingency, if the home is appraised at less than the sale price, you can choose not to move forward with the deal and you'll get your earnest money back. Alternatively, you may be able to use the appraisal to negotiate a new price.

Financing contingency

If you weren't preapproved for a mortgage when you put your earnest money deposit down – or even if you were – and then you don't get approved, a mortgage contingency can protect you. The finance contingency gives you the right to walk away and get your earnest money back as long as this contingency is listed in the agreement.

Contingency for selling an existing home

Some contracts also include a contingency for selling your existing home. If you can't sell the home you currently own before you close on another home, this contingency may let you back out of the deal with your earnest money in hand.

Should you waive a contingency?

In a hot real estate market, some buyers feel pressure to waive contingencies; for instance, they may consider this if they're absolutely certain they'll qualify for a mortgage. However, it's never a good idea to waive the appraisal or inspection contingencies. Those contingencies are there to protect you.

How to protect your earnest deposit

There are a few steps you can take to protect your earnest money.

Step 1. Use an escrow account

The real estate market isn't immune to fraud. As a result, you should never give your earnest money directly to the seller or a real estate brokerage. Instead, go with a third party such as a title or escrow company, which will hold your earnest money for you.

You'll usually pay by certified check, wire transfer or personal check. Your check should be made out to that third party, and you can keep a copy of the check and request a receipt. The funds are then held in the escrow account until closing.

Step 2. Know your contingencies

Contingencies are in place to protect both the seller and buyer, so you should understand every scenario where you and the seller can back out and what impact that would have on your earnest money. Be sure you're comfortable with the contingencies and are confident any actions you take won't result in losing your good faith deposit.

Step 3. Stay on track with your responsibilities

To protect the seller, the purchase agreement will typically include a timeline for when every aspect of the process has to be met, such as the date by which you need an inspection done or when the mortgage should be approved.

If you miss those deadlines, there could be grounds for the seller to back out of the deal with your earnest money in hand. Most sellers won't rescind the deal the minute you miss a deadline, but if you take too long, it could be a deal breaker.

Step 4. Put it all in writing

A home is one of the largest purchases many of us will make. It's important to protect your investments along the way, which is why you should put everything in writing. This includes any changes to the timeline and buyer responsibilities. Make sure the purchase agreement lays out who gets the earnest money if the contract is canceled.

For instance, if the inspection fails and the buyer will get to keep the earnest money, state that in the contract. If the buyer has a change of heart and the seller will keep the earnest money, lay that out as well. Everything should be explained in detail in the contract.

Example: Earnest money in practice

Whether a buyer or seller keeps their earnest money can depend on the situation. Here are a few scenarios that show how an earnest money deposit and contingencies can protect both the buyer and the seller:

Situation A: The forfeited deposit

Alex, Taylor and Sam are all selling their homes. Charlie is a home buyer who has looked at all three houses and wants one of them but can't quite decide which one.

Charlie doesn't want to decide on a single house just yet and makes a good faith deposit on all three houses. Alex, Taylor and Sam each take their homes off the market and inform their other potential buyers that Charlie wants the house.

Later, Charlie decides to buy Alex’s house. Taylor and Sam now have to put their homes back on the market and start looking for buyers all over again. Luckily, Charlie’s earnest deposits are Taylor’s and Sam’s to keep. This offers them some compensation for the time and money they lost due to Charlie backing out of the sales.

Situation B: The contingency option

Charlie makes a single deposit to Alex, but discovers the house is infested with cockroaches after a professional home inspection. Luckily, Charlie has a home inspection contingency in the purchase agreement and decides not to buy. Because of this contingency, Charlie gets the earnest money deposit back from Alex. Charlie is then able to make an offer on Sam’s house with the money.

Situation C: The failed offer

Charlie makes an offer to buy Sam’s house in a competitive market and makes an earnest money deposit. Once they accept the offer, Sam turns down other competitive offers from other buyers. To secure an offer, Charlie offered to waive any contingencies when making their offer. Unfortunately a sudden financial downturn causes the housing market to cool and Charlie loses their job.

The job loss means that Charlie is unable to get final approval for a mortgage and withdraws their offer. Because there were no contingencies in place, Charlie is required to forfeit their earnest money deposit.

While this is unfortunate for both parties, Sam is able to keep the earnest money to help cover the potential losses from not being able to sell their house sooner. Charlie is also protected against potentially being sued for breach of contract.

The bottom line

Earnest money can protect a home buyer if something is wrong with a property, and also the seller if you simply want out of the deal. Going the extra mile with a Verified Approval or an earnest money deposit can also prove to a seller that you're serious about your offer, making your offer stand out from other buyers.

Ready to begin the home buying process? Apply online today to see if you qualify for approval.