When you make an offer on a home, the seller may ask you for something called an earnest money deposit. But what is earnest money? It’s a request that may sound intimidating, but it’s simply an upfront payment that shows your commitment to the purchase.
Still confused? Don’t feel bad. In this article, we’re answering common questions about earnest money and how to protect your deposit.
What is earnest money in real estate?
An earnest money deposit is an upfront payment the buyer makes as a sign of good faith. They’re most common in a seller’s market.
The role of earnest money is to protect the seller. After all, as soon as a seller accepts an offer, they take their home off the market. If the buyer backs out of the contract a month later, the seller will have lost the sale and missed out on other offers. But if a sale falls through because the buyer breaks the contract’s terms, the seller can at least keep the deposit. This helps to offset their lost time and money.
This doesn’t mean the seller always gets to keep the deposit, though. If the sale falls through because agreed-upon contingencies aren’t met, the buyer can safely back out of the deal without forfeiting their deposit.
How much earnest money is required?
Generally, an earnest money deposit is 1% to 3% of the home’s purchase price. But if a seller has already received multiple offers, you can strengthen your bid by increasing your earnest money. In some extremely competitive markets, buyers will offer as high as 10%.
To determine exactly how much you should offer, consult with your real estate agent.
Does earnest money go toward the down payment?
Yes, your earnest money will be credited toward your down payment at closing. Unlike closing costs, it is not an additional fee—it’s simply a deposit of your total payment.
For example, let’s say you make a $300,000 offer on a home. After signing the purchase agreement, you pay a 3% earnest money deposit of $9,000. Afterward, you obtain financing with a 10% down payment of $30,000. At closing, you will only owe your lender $21,000 since you’ve already paid $9,000.
When is earnest money due?
In most states, earnest money is due within three days after you sign the purchase agreement. You can pay the funds with a cashier’s check, a personal check, or a wire transfer. If your deposit is small enough, you may be able to pay with a money order. For safety reasons, avoid paying with cash.
How to protect your earnest money deposit
Real estate scams are common—and they’re only increasing. According to the FBI’s 2020 Internet Crime Report, 13,638 people fell victim to real estate fraud in 2020 alone. (That’s almost a 17% increase from 2019).
Protect yourself and your savings by following best practices when it comes to earnest money.
1. Don’t pay the seller directly
Your earnest money should go into a third-party escrow account, not the seller’s bank account. If a seller asks you to give them the money directly, be careful—it could be a scam. Instead, have a title company or an escrow company hold the money during the closing period.
2. Add contingencies to your offer
A contingent offer allows a buyer to back out of a purchase agreement safely. In other words, if the sale falls through because of an unmet contingency, the buyer can cancel the sale and get back their earnest money.
The downside is that contingencies can be dealbreakers in a seller’s market.
Thankfully, with the Knock Bridge Loan™, you can safely make a non-contingent offer without risking your earnest money. However, if you choose not to use a program like this, there are several types of contingencies that can protect your earnest money deposit.
Appraisal
Most lenders will only fund the amount that a home is worth according to an official appraisal. If you make an offer on a house and the appraiser values it below the purchase price, you have two options: pay the difference out of pocket or back out of the sale. With an appraisal contingency, you can back out without penalty.
Home inspection
This contingency allows you to walk away from the home if an inspection reveals major problems. During a home inspection, a professional will come to the house and check every accessible area. Problems like bug infestations, an unstable foundation, or a damaged roof may allow you to regain your earnest money.
Financing
You don’t want to be bound to a purchase agreement if your financing doesn’t come through. If you want to make an offer on a home before obtaining a mortgage loan, consider adding a financing contingency to the contract. This means, if your financing falls through, you can cancel your purchase agreement without losing your earnest money.
Home sale
Many buyers rely on the proceeds of their first home to fund the purchase of their next one.
But what happens if your offer on a new home gets accepted even though you can’t sell your former home? That’s where a sales contingency comes in. It allows you to close on the new home only if and when your old one sells.
Title
It’s frustrating to sign a purchase agreement only to discover there are expensive liens on the house. Title contingencies provide a way out if the seller can’t transfer the property to you free and clear. Luckily, this isn’t usually an issue.
3. Make an offer that’s competitive with cash and free of contingencies
Unfortunately, the more contingencies you have, the less attractive your offer is. Sellers will likely forego your complicated bid for a non-contingent offer because it represents less risk.
But how do you protect your earnest money without contingencies? One smart strategy is to make an offer competitive with cash with a program like the Knock Bridge Loan™. This allows you to forego sales and financing contingencies and add an extra layer of protection to your deposit.
Sellers prefer offers that are competitive with cash because they’re easier to close and less likely to fall through. With one of Knock’s home loan solutions, you can stand out in a crowded market and enjoy a smooth closing on your new home.
By Jenny Rose Spaudo