What is earnest money, and how much do you need?

When you make an offer on a home, you may need to put down an earnest money deposit to show you’re serious about completing the purchase. After all, the seller is taking a risk by agreeing to your offer and pulling the home off the market. If you back out and the deal doesn’t go through, they’ll be forced to start over, having potentially missed out on other offers during that time. Earnest money, also known as a good faith deposit, can help offset that risk and keep the transaction moving forward.

Earnest money is an amount of money paid toward the purchase of a home, which demonstrates the buyer’s good-faith intent to complete the transaction. This allows the seller to take the home off the market and stop considering other offers.

The purchase contract will include specific circumstances that will allow the buyer to cancel the purchase without losing their deposit. These are known as contingencies and are common with situations that involve a home inspection, property appraisal, and the buyer’s ability to secure a mortgage or sell their current home.

Earnest money amounts may be negotiated as part of the offer process, but they’re typically 1% to 2% of the sale price.

Earnest money is usually paid immediately or soon after the purchase contract is signed, and is held in an escrow account until closing. The purchase contract will dictate how, when, and to whom the money is released by the escrow agent if the purchase doesn’t go through.

Note: When you close on your mortgage, there may be another type of escrow account created by your lender to hold funds for property taxes and insurance. Don’t be confused by the similar names; there is no connection between that type of escrow account and the one used for earnest money.

On closing day, if everything has gone smoothly according to the purchase contract, the earnest money deposit is typically credited toward the buyer’s down payment and closing costs.

Your purchase contract should include specific contingencies, which are circumstances allowing you to back out of the contract without losing your deposit. If you decide to cancel for a different reason, you risk forfeiting some or all of your earnest money. Before submitting an offer, think about what contingencies are important to you, and review the contract carefully to make sure everything is covered.

It’s up to you what contingencies to include in your purchase offer. In general, having fewer contingencies can make an offer more attractive to sellers, but having more contingencies gives you more protection as a buyer. If you’re working with a real estate agent, they can make recommendations based on your circumstances, risk tolerance, and the real estate market in your area.

These are some of the most common contingencies in real estate, and what they cover: 

• Inspection contingency. If a home inspection reveals major issues that are listed in the contract, this contingency would allow the buyer to back out of the purchase or negotiate with the seller to cover the necessary repairs.
• Appraisal contingency. If the home appraisal returns a value lower than the agreed upon purchase price, this contingency would allow the buyer to back out or negotiate a new price. This contingency can be especially important when it comes to getting a mortgage, because the loan amount can’t be based on the sale price if it’s higher than the appraised value. That could leave the buyer scrambling to come up with enough cash to cover the difference.
• Financing contingency. If the buyer is unable to get a mortgage to buy the home, this contingency would allow them to cancel the purchase. Applying for a mortgage preapproval early in the process can help buyers avoid this situation.
• Home sale contingency. If a buyer needs to sell their current home in order to complete the purchase and isn’t able to do so within a certain time frame, this contingency will allow them to back out of the contract.

As a homebuyer, you ultimately get to decide how much you’re willing to pay for an earnest money deposit and what contingencies to include with your offer. A higher deposit with fewer contingencies could make it easier to land a home in a hot market. But make sure you weigh the risks and benefits before making an offer.