What is Earnest Money?

When you’re ready to make an offer on a home, you may consider giving the seller a cash deposit to show them you’re serious about going through with the purchase. This is called earnest money.

In return, the seller will typically stop showing their property to other interested buyers. While earnest money isn’t legally required, most sellers will expect a deposit before they agree to take their house off the market.

Earnest money can be an essential tool for buyers because it can help your offer stand out, especially in more competitive markets. But make sure you understand the fine print on earnest money — there are a few things you’ll want to keep in mind before writing any checks.

Who Benefits From Earnest Money?

Earnest money is a fairly standard part of any real estate transaction because the seller assumes a certain amount of risk by taking their home off the market. If your purchase agreement falls through, the seller has wasted time and potentially other offers from interested parties.

An earnest money deposit is meant to offset that risk. It’s also an effective way to prevent less serious buyers from making offers on multiple homes and retracting them after they decide.

During closing on a home, earnest money acts as a form of insurance for the seller. If you breach the terms of the contract and decide to walk away from the sale without a valid reason, the seller may get to keep the deposit to compensate for their loss.

If everything goes according to plan and the home sale goes through without a hitch, the earnest money deposit will be applied toward your down payment and closing costs.

Ask your real estate professional about the specific terms around your earnest money deposit.

Earnest Money Vs Down Payment

While an earnest money deposit and down payment are both initial costs of buying a home, they each serve different purposes in the overall transaction.

When you buy a home, the down payment goes toward the total amount of your home. Typically, a down payment ranges between 3% and 20% of the home’s purchase price. Down payments help determine your loan-to-value ratio—a figure that lenders use to assess the risk of your loan.

Bigger down payments can improve your loan-to-value ratio and make it less likely that lenders will attach additional costs to your loan.

Smaller down payments can weaken your loan-to-value ratio and make lenders more likely to attach additional fees that mitigate their risk.

For example, private mortgage insurance (PMI) is required by lenders if you put down less than 20%.

On the other hand, an earnest money deposit is meant to reassure the seller that you intend to buy. The deposit money is usually kept in an escrow account during the transaction and then eventually applied to the down payment or closing costs when the sale goes through.

Published by Better.com