Does Earnest Money Go Towards Down Payment or Closing Costs?

Earnest money is a financial commitment from a buyer to a seller in real estate transactions. This deposit demonstrates the buyer’s serious intent to purchase a home, assuring the seller the property will not be taken off the market without cause. Its application and conditions are detailed within the purchase agreement, which guides the entire transaction.

What Earnest Money Is

Earnest money is a deposit a buyer provides to demonstrate a genuine intention to purchase a property. This financial commitment signals to the seller that the buyer is serious about their offer. It functions as a good-faith deposit, strengthening the buyer’s offer in competitive markets.

The amount of earnest money is often a percentage of the home’s sale price, typically 1% to 3%, but can reach 5% or 10% in competitive markets. It can also be a fixed sum, such as $5,000 or $10,000. This deposit is generally paid shortly after the offer is accepted and the purchase agreement is signed, usually within 24 to 72 hours.

Once paid, the earnest money is not given directly to the seller. Instead, it is typically held by a neutral third party in an escrow account. This third party can be a title company, an escrow agent, or a real estate broker’s trust account, ensuring the funds are safeguarded until the transaction closes. The earnest money is not an additional cost but rather a portion of the total funds the buyer will need for the home purchase, paid upfront.

How Earnest Money is Applied at Closing

At closing, the earnest money deposit is typically credited towards the buyer’s total cash due. The funds are not returned as a direct refund but are applied to reduce the amount the buyer needs to bring to the closing table. The specific application is always outlined in the purchase agreement.

One common way earnest money is applied is towards the down payment. For example, if a buyer is purchasing a $300,000 home and plans to make a 10% down payment of $30,000, and they provided an earnest money deposit of $5,000, that $5,000 would be subtracted from the $30,000 down payment. This would leave the buyer needing to bring $25,000 for the down payment at closing.

Should the earnest money deposit exceed the required down payment, or if agreed upon in the contract, it can also be used to cover a portion of the buyer’s closing costs. For instance, if a buyer’s down payment is $8,000, but their earnest money deposit was $10,000, the extra $2,000 could be applied towards other closing expenses such as loan origination fees or title insurance.

Most commonly, earnest money reduces the overall cash the buyer needs to bring to closing, contributing to both the down payment and various closing costs. This integrated application streamlines the financial process, making earnest money part of the buyer’s overall payment for the property.

Factors Affecting Earnest Money Disposition

The disposition of earnest money is largely governed by the contingencies stipulated in the purchase agreement. These contingencies are specific conditions that must be met for the transaction to proceed, and they provide a mechanism for the buyer to withdraw from the contract without forfeiting their earnest money. Common contingencies include financing, home inspection, and appraisal.

A financing contingency protects the buyer if they are unable to secure a mortgage loan despite making a good-faith effort. Should the buyer be denied financing, this contingency allows them to terminate the contract and receive their earnest money back. Similarly, a home inspection contingency permits the buyer to withdraw if significant issues are discovered during the inspection and the seller refuses to address them or adjust the price.

An appraisal contingency is another common protection, allowing the buyer to renegotiate or exit the contract if the home appraises for less than the agreed-upon purchase price. If the appraisal comes in low, the buyer can walk away with their earnest money, renegotiate the price, or choose to cover the difference. These contingencies protect the buyer’s deposit if the deal falls through.

However, if a buyer defaults on the contract without a valid contingency, the earnest money may be forfeited to the seller. This occurs if the buyer backs out for reasons not covered by the agreed-upon contingencies, fails to meet contractual deadlines, or breaches the terms of the purchase agreement. The forfeiture compensates the seller for the time the property was off the market and for any potential missed opportunities. The release of earnest money, whether to the buyer or seller, typically requires mutual agreement, and disputes can sometimes necessitate mediation or court intervention.