What is an earnest money deposit and how does it help me?

In the current housing market it can be difficult to determine which offer to choose during your home sale. There are many factors to consider such as the sale price, closing date, and even the type of financing your buyer is using. 

But there’s another good indicator of a strong offer that many prospective home sellers fail to consider. The earnest money deposit, or EMD. In this article we will explore the earnest money deposit, what it’s for, and how it can help you vette home buyers to get your ideal offer. 

What does earnest money mean in real estate?

Earnest money is the term for a type of deposit that is put down on a house at, or near the time of contract, well before closing to show that a buyer is serious about purchasing the home. Think of it as a good faith deposit between a buyer and seller. 

This deposit is held in an escrow account by a real estate attorney, escrow company, or title company during the inspection contingency and contract period. 

This earnest money deposit is common in real estate purchases and sales, but is often overshadowed by more obvious benefits in a sales contract such as the purchase price. 

What does an earnest money deposit do?

After a buyer signs a purchase agreement there are often contingency periods, or time frames in which certain requirements of the purchase contract must be satisfied. These can include two common contingencies for inspections and financing. 

During these periods the buyer can be excused from fulfilling their part of the contract in specific situations. For example: if major repairs are found to be needed during the inspection period, and the seller refuses to make those repairs, the buyer has the opportunity to nullify the contract during the inspection window. 

But what happens if the buyer wants to back out of the contract outside of a contingency period? This is considered a breach of contract, and most real estate contracts specify what remedies can be taken by each side of the sale in the event of a breach. When a buyer breaches the contract, the seller’s sole remedy is usually keeping the earnest money deposit. 

Because real estate transactions take time, a seller can spend months under contract, unable to entertain other offers, only to have a buyer decide at the last minute they don’t want to close. That can mean additional mortgage payments, taxes, and insurance for the seller. The earnest money deposit helps to compensate a seller for those losses. 

How much is normal for an earnest money deposit? 

When working with a traditional real estate agent on a sale, a seller might expect as much as 4-5% of the purchase price as a deposit, meaning as much as $20,000 on a $400,000 home. However, this is more common with higher value homes in which the cost of holding the property is significantly higher. 

Typically 1-2% is considered acceptable in most on-market financed transactions, or $2000 on a $200,000 house. 

That means if your buyer fails to uphold their end of the contract, you keep a few thousand for your trouble. 

Additionally, it’s not uncommon to ask for additional earnest money if extending a contract for reasons outside of the contingencies. The additional time it takes to close will end up costing you as the owner, so ensuring that the buyer has extra skin in the game helps to mitigate some of the risk. 

EMD’s for cash sales

In a cash sale to an investor, earnest money is one of the most important aspects of the offer contract. Because most cash buyers look to close quickly, and without any contingencies (they don’t need financing periods if they have cash and usually buy as-is without inspections), the earnest money deposit amount will be lower than a traditional sale. This is due to the increased risk to the buyer. Expect $500-$1000 on average when working with good investment companies. 

Be extremely wary of any investor who offers $10 or $100 as earnest money, as there is little incentive for that buyer to close if the deal isn’t perfect for them. They may even consider that small sum a fee which allows them to tie up and market a property to their buyers for weeks or months at little cost and risk. 

Key takeaways

The earnest money deposit in real estate offers protections and remedies to a seller when a buyer fails to honor a real estate contract. While the amount doesn’t change the total you take home from the sale, it can be a good indicator of how serious a buyer is. 

Always look at the amount of earnest money being offered when reviewing a purchase and sale contract and consult with your real estate agent if you have any questions about the amount or how it will be collected. 

If you do decide to sell to a cash buyer, ensure they are funded and offer a fair earnest money deposit for your property, especially if they use no inspections as a selling point! 

And if you are buying a home, be sure to consider how much earnest money you want to offer to make your offer stand out, but protect your earnest money by consulting with your agent before making an offer.