The current housing market is booming, driven mainly by young homebuyers. The National Association of Realtors Research Group reported that 39% of homebuyers are under the age of 40. With such a competitive market, it’s important to understand the ins and outs of the home-buying process.
When you find a home you love and are ready to move forward, you usually have to make an earnest money deposit. The deposit acts as an initial prepayment made to the seller and proves you’re serious about completing the deal. Here’s how earnest money deposits work and how much money you should consider setting aside.
What is an earnest money deposit?
When you make an offer and the seller accepts, they will take the house off the market. That’s a big decision; taking a home off the market means other prospective buyers can’t see it or make offers, so sellers typically want some form of proof that you’re committed to buying their home.
To show you plan on completing the deal, you’ll typically have to make an earnest money deposit. Earnest money deposits are also known as good faith deposits or pledges.
These deposits are often delivered when you sign the house’s purchase agreement or sales contract. The offer contract will outline conditions for the deposit, detailing under what circumstances the seller has to refund the deposit.
Once the home purchase contract is signed and the earnest money deposit is paid, both the seller and the buyer are obligated to move forward with the transaction.
How much earnest money should you put down?
An earnest money deposit is separate from your mortgage, and it basically works as an advance payment of the down payment you have saved.
According to Chase — a major bank that issues home loans — the average good faith deposit is between 1% and 3% of the home’s price in most markets. So for a home that is $300,000, that means you might have to pay the seller between $3,000 and $9,000 in earnest money.
The total earnest money deposit you make depends on a range of factors, including how competitive the real estate market is in your area. In certain markets, you might have to come up with as much as 10% of the home’s purchase price to stand out from other buyers. Your real estate agent can advise you on how much money you’ll likely need for your deposit based on local market conditions.
How to make an earnest money deposit
To make an earnest money deposit, follow these steps:
- Make an offer on the home. Work with your real estate agent to come up with an offer for the house you want to purchase. If your offer is accepted, you and the seller will sign the real estate purchase agreement.
- Find out how much the earnest money deposit is. Your real estate purchase agreement will likely detail how much money you need to pay for the earnest money deposit.
- Verify that the money will be held in escrow. Before handing over your money, verify with the title company or real estate broker that your deposit will be held in an escrow account — a legal arrangement where your money is held by a third party. Your earnest money deposit isn’t released to the seller until the deal is completed and you close on the home.
- Pay the earnest money deposit. Typically, your contract might state that the deposit needs to be paid to the title company. However, in some locations, the real estate broker could hold the deposit. Never pay the earnest money deposit directly to the seller; if the deal falls through, you could lose the money entirely, so it’s a good idea to give the deposit to a neutral third party.
Can you get your deposit back?
One of the most common questions home buyers have about earnest money deposits is if they are refundable. How the deposits are handled is typically based on what’s in your purchase agreement or sales contract.
In general, deposits are non-refundable if the deal falls through due to a buyer’s circumstances. For example, if you struggle to get approved for the mortgage requested, you could potentially have to forfeit the deposit unless you had contingencies included in your contract.
To protect yourself, consider working with your real estate agent to make sure your sales agreement includes contingencies for how your earnest money deposit is handled if you can’t secure financing or the home inspection uncovers significant issues.
What happens to earnest money at closing?
When you make an earnest money deposit, the title company or real estate broker generally holds the funds in escrow. The money typically remains in a separate account until the deal is finalized.
Once you reach your real estate closing date, the escrow company typically releases your funds from escrow. You might then use the earnest money deposit as part of your mortgage down payment or to help cover closing costs.
What happens to earnest money if a deal falls through?
If a deal falls through, how the earnest money deposit is handled depends on the sales agreement. Earnest money deposits might be refundable or non-refundable based on the contract.
Typically, a small cancellation fee might be deducted from the deposit amount. The title company or real estate broker might decide how the refund is handled based on the purchase agreement or sales contract. The contingencies included in the contract will typically determine who keeps the deposit.
For example, these are common scenarios that can occur during the home-buying process that could potentially affect the earnest money deposit:
- The property fails home inspection. If you have a home inspection contingency and the house fails due to serious issues, such as mold or termite damage, the seller might need to refund the deposit.
- The buyer fails to secure financing. Many buyers opt to include a financing contingency in their deposit agreements. If you don’t have a financing contingency in your contract as a homebuyer and can’t get approved for a mortgage, you might lose your deposit.
- The house appraises for less than its sales price. One of the most common mortgage questions first-time buyers have is, “What happens if the home is appraised for less than its asking price?” In certain cases, the lender won’t approve you for the requested mortgage amount, and you might need to come up with the difference in cash or potentially walk away from the deal. If you have a financing contingency in your contract, you might receive the deposit back. Otherwise, you might lose it.
- The buyer changes their mind. If you put down a deposit on a home and then have a change of heart and fall in love with another house, you will probably lose your deposit. In this case, the seller might get to keep the deposit as compensation for the time they lost due to you backing out of the home sale.
To protect your deposit, it’s a good idea to put everything in writing. Your contract should clearly define contingencies and define under what circumstances your deposit could be returned.
Can you get your earnest money back if the home inspection doesn't go well?
Putting down thousands of dollars on a home can be nerve-wracking. You might be wondering what happens to your deposit if substantial issues are found during the home inspection.
Before making a deposit, it could be wise to include a home inspection contingency in your contract. If you have that contingency in place and the inspector finds problems, such as issues with the house’s foundation or roof, you might be able to receive your deposit back.
In some highly competitive housing markets, buyers might consider waiving the home inspection contingency to make their offer more attractive to sellers. Keep in mind that if you waive the home inspection contingency and find issues in the home, you could lose your earnest money deposit.
The bottom line
The earnest money deposit is a payment you make in good faith to the home seller to show that you’re committed to buying the home. Depending on your location, the deposit is usually 1% to 3% of the home’s price, and it could potentially be put toward your down payment when you close. As long as you have contingencies in place, you might get the deposit refunded under certain circumstances.
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