Earnest Money: What It Is, How It Works, and Why It Matters

 

What Is Earnest Money?

Earnest money, also called a good faith deposit, is money a homebuyer pays after the seller accepts their offer. It shows the seller, “I’m serious about buying this home.”

It makes sellers more confident about you when you put something at risk, in this case your money to show or express you are serious because in the back of the mind of the seller, they will always want to know if you are planning to move forward. By earnest money, you prove that you are committed in buying the property.

Even though earnest money is not legally required, it is standard practice in most real estate transactions. In today’s market, submitting an offer without it can make your offer look weak. Sellers often expect it because it shows you’re acting in good faith.

But what happens to that money?

That’s exactly what we’re going to cover in this guide. We’ll walk through:

• The typical amount buyers put down
   
• Where the money is held
   
• When it is refundable
   
• When it may be forfeited

 

What Is the Purpose of Earnest Money?

The main purpose of earnest money is to simply earn the seller’s trust that you are serious about buying the property they sell.

Shows Serious Commitment

In the market, the sellers know that people are actively looking for properties. Whenever they encounter a person showing interest in their property, they don’t automatically decide that you are their final buyer. They know that people are still looking for other options, which is why. It has become a custom that people would put down an earnest money so that sellers will have a sense of security that they have finally found a buyer for their property and that they cannot simply easily back out.

Allows the Seller to Take the Home Off the Market

Once the seller accepts an offer with earnest money, they will have the option to stop the marketing of their property to other potential buyers, which will allow the buyer to have more time in completing the inspections, financing, and other requirements in the contract.

Example Scenario:

Jonathan found a home he really liked. Lemuel, the seller receives two offers. One offer includes earnest money, and the other does not. Lemuel will most likely choose the offer with earnest money because it shows stronger commitment and lowers the risk of the buyer backing out.

 

How Much Is Earnest Money?

There is no exact amount as to how much you are going to put down as your earnest money since it is only traditional and not necessarily mandated by any law. However there is a range as to how much people typically put down.

Typical Range

According to Zillow, most of the time, earnest money is about 1% to 3% of the home’s purchase price which is the generally accepted amount. A house priced at $200,000 will have an earnest money of somewhere between $2,000 to $6,000.

Competitive Market Situations

In very competitive market conditions, they who have the higher earnest money deposit will be considered by the seller more. Some would go as high as %10-%15 if they really want their offer to be considered.

 

When and How Is Earnest Money Paid?

 

The earnest money is paid after the seller accepts your offer. The buyer and seller will agree to the contract terms (offer) and then once both parties have signed, the buyer will then deposit the earnest money through escrow within the specified date in the purchase agreement (what the offer becomes after signing).

 

Why Escrow and not the Seller?

The reason why earnest money is not paid directly to the seller is to protect the seller from spending it and the buyer as well. In a real estate transaction, since escrow is a neutral third party this ensures that it is not represented by either the buyer or the seller. Having the earnest money in the seller will raise doubts to the buyer.

Common parties that may hold earnest money include:

• Title companies
   
• Real estate brokerages
   
• Escrow companies
   

What Happens to Earnest Money at Closing?

It is applied toward the total amount you need to pay to complete the purchase.

Most of the time, earnest money is credited toward your down payment or closing costs. This helps reduce the amount of cash you need to bring on closing day.

Since the money is already being held in escrow, it is simply transferred to help cover part of what you owe on the home purchase.

Applied Toward Down Payment or Closing Costs

At closing, your earnest money is used to help pay:

• Down payment
   
• Closing costs
   

This is one of the benefits of earnest money because it helps lower the amount of cash you must prepare when finalizing the purchase.

Simple Numerical Example

Here is an easy example to understand how this works.

Suppose you are buying a home for $200,000 and you agree to a 10% down payment. Your down payment would be $20,000.

If you already paid $3,000 in earnest money, that amount will be applied toward what you owe. Instead of paying the full $20,000 at closing, you would only need to bring $17,000 more to complete the down payment.

This means the earnest money does not disappear. It becomes part of your total payment for the home as long as the transaction is completed successfully.

 

When Is Earnest Money Refundable?

Earnest money is not always at risk. In many cases, buyers can get their deposit back if certain conditions in the contract are not met. These conditions are called contingencies.

What are Contingencies

Contingencies are rules written into the purchase contract that protect the buyer. They are considered as safety conditions that must be met before the sale can move forward.

They act as a safeguard for both the buyer and the seller that if one contingency fails, then it has gone as fairly as possible and that the buyer is not liable for the failure.

Common Refundable Situations

 

Inspection issues are one of the most common reasons. If the home inspection finds major problems such as structural damage, electrical issues, or expensive repairs, the buyer may be able to cancel the contract and get their earnest money back if an inspection contingency is included.

Loan denial is another common situation. If a buyer has a financing contingency and their loan application is rejected, they can usually cancel the contract and receive their earnest money back.

Low appraisal values can also allow buyers to recover their deposit. If the home appraises for less than the agreed purchase price and the buyer cannot negotiate a lower price with the seller, they may be able to cancel the deal and recover their earnest money.

Title problems may also make earnest money refundable. If there are legal ownership issues, liens, or other title defects that cannot be resolved, the buyer can usually back out without losing their deposit.

 

When Can You Lose Your Earnest Money?

One of the most common ways buyers lose earnest money is by backing out of the deal without a valid contingency reason. Even in other forms of transactions, not just in real estate, one party cannot simply back down without a valid reason, most especially if the contract is active. This would cause damages to the other party and would have the option to sue.

Missing contractual deadlines can also cause buyers to lose their earnest money since in the purchase agreement, you have already agreed to fulfill parts of the responsibilities on a specified date, although there is also what is called an "automatic extension," and this applies when other agencies, departments, or companies material to closing cause delays.

Another way to lose earnest money is by deliberately breaking the contract terms. This can happen if the buyer simply changes their mind, finds another home they like better, or decides not to proceed without a contract-approved reason.

In general, if the buyer cancels the deal without contractual protection from contingencies, the seller typically keeps the earnest money deposit.

 

Is Earnest Money Required by Law?

Earnest money is not required by law, including in the state of Iowa. It is simply a common practice in real estate transactions. While it is usually expected in most home purchases, there is no legal rule that forces a buyer to pay earnest money when making an offer.

 

 

 

 

 

 

 

 

Discover Amazing Sioux City Properties

Explore unique homes, commercial spaces, and investment opportunities in Sioux City. Find the perfect property to fit your lifestyle or business vision.

Browse Our Listings