What is Earnest Money and How Does it Work?

Imagine walking into an open house with your real estate agent and immediately knowing you’re home. The house has the crown molding of your dreams, a spacious open layout that’s perfect for entertaining, and beautiful natural light in seemingly every room.

You make an offer, and the seller accepts! You both sign a contract called a purchase agreement that outlines the terms of the transaction. You’ve already told the seller how much you adore the house, but there’s another way to show how committed you are: earnest money.

Earnest money is a deposit you make after signing the purchase agreement but before closing, to demonstrate that you’re committed to the property and want the sale to be successful. It’s also known as a “good-faith deposit.” Though the amount will vary based on where you live, it’s typically between 1% and 5% of the sale price of the home.

Earnest money isn’t always required, but it is common, especially in more competitive real estate markets.

What’s the point of earnest money?

In addition to making the buyer’s seriousness known, earnest money protects the seller. 

Once the agreement is signed, the seller takes the home off the market. If the sale goes through, the earnest money goes into an escrow account until closing. It is typically then applied to the down payment and/or closing costs. It’s basically just prepaying a bit of what the buyer will eventually pay to buy the home.

But if the buyer pulls out, the seller will have to put the home back on the market and start the process all over again. The previous agreement will have been a waste of time and energy they could have used to find a better-suited buyer.

If earnest money was part of the transaction, the seller gets to keep it if the buyer pulls out because they’ve changed their mind or found a home they like even more. So the seller gets a bit of compensation for the hassle of having to put the home back on the market and find a new buyer.

Since the buyer can lose the money if they back out of a sale, earnest money can also deter buyers from putting in offers on multiple homes.However, there are some situations where the buyer will get their earnest money back if the sale doesn’t go through.

How do earnest money deposits work with traditional title companies?

In most situations, a title company will call or email a homebuyer to let them know the earnest money is due. Traditional title companies will only accept wire transfer or certified checks, which are costly and often force homeowners to make a special trip to the bank. Wire fraud in real estate is also one of the fastest growing cybercrimes, and communicating about money movement via email and phone can make homebuyers particularly vulnerable.  

How do earnest money deposits work with Spruce?

Product image of Spruce Homeowner Dashboard

Rather than running to the bank for a certified check or dealing with risky wires, in most cases you can pay your earnest money deposit electronically in Spruce’s homeowner dashboard. When it’s time to make your deposit, you’ll receive a notification from our team. From there, you can sign in to pay earnest money safely, securely, and at your convenience––eliminating the stress of errors or possible wire fraud.  

How contingencies work, and how they can safeguard your earnest money

Purchase agreements generally include several loan contingencies, or clauses that spell out standards that must be met in order for the sale transaction to proceed.

If the sale falls through because something violates a contingency in the purchase agreement, the buyer will get their earnest money deposit back.

Common contingencies include:

  • Home inspection contingency: If a home inspection unearths a serious issue with the foundation, for example, the buyer would be able to get their earnest money back.
  • Appraisal contingency: If an appraisal of the home ends up being significantly lower than the sale price, the buyer can decide to walk away and get their earnest money back.
  • Contingency for selling an existing home: If the buyer is putting in an offer on a home before they’ve sold their current home, they can add a contingency that allows them to walk away with their earnest money if their current home doesn’t sell in time for them to buy the new home.
  • Clear title contingency: If the buyer buys title insurance and the title company discovers an issue with the title that could be difficult to fix, this contingency allows the buyer to pull out of the deal and keep their earnest money.
  • Mortgage financing contingency: If a buyer puts in an offer on a home and is then denied financing by their lender, they can pull out of the deal without forfeiting their earnest money.

There is often a contingency deadline spelled out in the purchase agreement. If the home has a contingency violation, the buyer must make that clear before the deadline. Once the deadline passes, the seller can keep the earnest money regardless of the issue with the home.

How to know how much earnest money is appropriate

Though earnest money is often between 1% and 5% of the sale price, it can vary a lot depending on where the home is and other factors.

If you’re in a hot market where homes sell quickly and bidding wars are common, you may want to bump up the size of your earnest money deposit. If the home is brand-new construction in a coveted neighborhood, the seller may expect a larger sum of earnest money. If the home has been sitting on the market for weeks or months, you may be able to put a bit less earnest money down. Different parts of the U.S. often have their own customs when it comes to earnest money, as well.

When in doubt, consult your real estate agent to get a feel for what the seller may be expecting in terms of earnest money. It could make or break your chances of getting your dream home.

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