The homebuying process can be a challenge, particularly when there's so much demand and a limited supply. Generally, buyers put down earnest money to demonstrate that they are serious about buying a home. On the resale market, this deposit could even make the difference between closing on the home of their dreams or losing out to someone else if the other buyer is willing to put down more earnest money. However, it's important to note that in new home sales, the deposit is typically a fixed amount set by the homebuilder, making it an important first step toward purchasing a new construction home but not a competitive bargaining tool.
But what is earnest money, and how does it work? Let's break down this crucial piece of the homebuying process so you know exactly what to expect.
What is Earnest Money?
An earnest money deposit, or a good-faith deposit, is the amount of money you put toward a new home to show that you're serious about your offer. The primary purpose of this deposit is to provide peace of mind to the seller. If the seller takes the property off the market and the deal falls through, they may lose money in the process. Thus, putting funds down first can alleviate the seller's fear of that happening.
Advantages of Providing an Earnest Money Deposit
As we said, the primary advantage of providing money upfront is that it shows the seller you're serious about purchasing the home. However, another benefit of earnest money is that it can give you a competitive advantage over other buyers. Even if other individuals put down a deposit, you can offer more money upfront, putting you in a better negotiating position. Again, this is not necessarily true of new home construction, where the amount of earnest money is typically fixed by the builder, and homes are generally offered on a first-come-first-served basis rather than through an open bid process.
Determining the Right Amount
Typically, an earnest money deposit is around one or two percent of the home's market value. However, in a competitive resale market, sellers have more negotiating power, so they can request a higher deposit. As such, one advantage of going with a new construction home is that you likely will not have to increase the amount of your earnest money deposit to go under contract on a new home.
At this point, you may be wondering, "Does earnest money go towards my down payment?" And the answer is—yes, it does. Because of this, it doesn't make sense to put down any more money than you have to.
Is Earnest Money Refundable?
Generally speaking, as long as a buyer acts in good faith and qualifies for a home loan and the lender is prepared to timely close, earnest money is refundable. An earnest money deposit comes with common contingencies, and until a deal is complete, funds are held in an escrow account (more on that later) if purchasing a resale home, or by the homebuilder. This way, if contingencies aren’t met and the deal falls through, the buyer gets their money back. There are also scenarios in which the private seller or homebuilder may get to keep the money and the property.
Here are some examples of when the money may go to the buyer or seller:
- Making Multiple Deposits—If you put earnest money down on multiple homes, you may have to forfeit any deposit on a home you don't wind up buying. In this case, the deposit was to compensate the seller for taking the property off the market while you decided.
- Inspection Contingency—One example of a contingency is if the home fails an inspection. In this instance, you have the opportunity to safely back out of the deal with a full refund of your earnest money.
- Note: This contingency likely does not apply to the purchase of a new construction home, in which the builder has to obtain a certificate of occupancy from the local government declaring that the home complies with building codes and is safe to inhabit. In addition, most builders offer a limited warranty to cover necessary repairs on covered items after move-in.
How Do You Protect Your Earnest Money?
With a resale purchase, your money should be placed in an escrow account to protect the deposit for you and the seller. An escrow account is held by a third party (not the buyer or seller), and the funds are only made available once the deal is finalized. If purchasing a new construction home, the money will likely be held by the builder until it’s determined whether the builder will retain the deposit or not.
Remember that if you have contingencies on your deposit, the money may go to the seller if the deal falls through. That’s why it’s important to fully understand the terms of a purchase agreement before signing a contract.
Contingencies you might want to consider requesting for a resale home include:
- Appraisal Contingency—If the house appraises for less than the purchase price, you can adjust your deposit to reflect the new total and/or you can back out of the contract altogether (and keep your earnest money)
- Inspection—A four-point inspection is a standard procedure to ensure the home is livable. If the property fails this (or a different) inspection, you can get a refund.
- Title—Some properties may have outstanding taxes or liens. This contingency allows you to back out if the title has too many issues.
- Home Sale—Sometimes, buyers need to sell their existing property before buying a new one.
- Mortgage—This contingency gives the buyer a set timeframe to secure a mortgage for the new property, or they get their deposit back and the seller can re-list the home.
Again, note that many of these contingencies will likely not apply to new home construction, given the unique nature of the homebuilding process and the different laws and guidelines by which it’s governed, which may serve to streamline and simplify your homebuying experience.
Earnest Money Is More Important Than You Might Think
Earnest money plays a vital role in the homebuying process, serving as a sign of the buyer's intention to purchase a property. It not only helps establish trust and commitment between the parties involved but also provides a level of assurance to the seller.
If you’re considering purchasing a new home, we make it easy to begin your search today. With so many move-in-ready properties available, you have more options than you might realize.
