If you're a first-time homebuyer, you're probably hearing a lot of new terms about homeownership and wondering what they all mean. During the homebuying process, one new phrase you may hear thrown around is "earnest money." But, what does that mean? What is it for? Do you really need to worry about it? Let’s break it all down.

What Is Earnest Money?

This term refers to a type of security deposit you'll put down to show the home seller that you are serious about purchasing their home. This is typically 1-2% of the asking price but can go up to 10% depending on market interest. It differs from a down payment in that a down payment is a promise to the mortgage lender that you can pay back your home loan. It may also be referred to as an escrow deposit or good faith money.

What Purpose Does It Play?

As stated above, earnest money shows the home seller that you are serious about moving forward with purchasing their property. Making an earnest money deposit allows you extra time to secure further financing and conduct a title search, appraisal, and inspections before making your final offer. If the seller knows you are serious about purchasing their property, they may cease accepting other offers, or put other offers on hold while awaiting yours.

When is the earnest money given?

When you decide to purchase a home, you and the seller enter into a contract. This contract does not obligate you to buy the home because the appraisal or home inspection may reveal problems with the property. Instead, the contract ensures the seller will take the house off the market during the inspection and appraisal process. For most transactions, earnest money is given when this contract is signed. In other cases, it can be attached to the offer. Once deposited, the funds are typically held in an escrow account until the closing.

What Does It Go Towards?

Because earnest money is put down to convey the intention of purchasing the home, once the home is officially purchased, the earnest money may be added to the down payment and/or closing costs.

In the event the home purchase does not go through, the earnest money may be returned to you if the reason for not purchasing the home is clearly stated in the contract. For example, if the contract states that you do not have to buy the home if the appraisal comes back lower than the asking price, the seller would return the earnest money. However, if this is not stated in the contract and you choose to not follow through with the purchase, you may forfeit all earnest money to the seller.

Keep in mind that you may be subject to forfeiting your earnest money for a number of other reasons, so it’s important to discuss the details before handing over the money. Some other factors that could lead to the loss of your earnest money include taking too long to complete certain milestones within the timeframe specified by the seller or agreeing to a non-refundable deposit.

Does Earnest Money Go Towards Closing Costs?

Assuming a successful home purchase, where the earnest money ends up is defined in the sales contract between you and the seller. After it is released from the escrow account, you may choose to apply it to the closing costs, down payment, or have it returned to you for other home-buying expenses. Although it is up to you, it must be included in the sales contract to be valid.

How Is the Amount Calculated?

The amount of earnest money required can vary based on a few factors. The most important factor is the real estate market in the area you're buying. If a home receives many offers, a higher earnest money deposit may be required to secure the contract. In other cases, the amount may be determined by dollar value, typically ranging from $5,000 to $10,000. The more competitive the market, the higher the sum is likely to be in order to show how serious you are as a buyer. Keep in mind the contingencies of the sales contract. You'll want to put down enough to show intent and secure the contract, but not so much that you risk extra money you can't afford to lose in the event the contract is not followed through.

Mistakes to Avoid

Keep in mind that you may be subject to forfeiting your earnest money for a number of reasons if you aren’t careful. Some factors that could lead to the loss of your money include timing, agreeing to a non-refundable deposit, backing out of the agreement, or not outlining contingencies.

In the case of timing, note that the seller has the right to specify a timeline for milestones in the process, including home inspections and finalizing the terms of your mortgage loan. In the case that you don’t meet the deadline of the specified requirements, it is in the hands of the seller to decide whether or not to cancel the deal altogether. If they do, it is in their rights to keep the earnest money.

For more information on Earnest Money and the home-buying process, please visit the following websites.

https://selling-guide.fanniemae.com/

https://guide.freddiemac.com/app/guide/content/a_id/1003329

https://www.fhanewsblog.com/fha-mortgage-loan-rule-for-earnest-money-deposits/