When you buy a home, one of the provisions of your purchase contract is something called the earnest money deposit. Earnest money is a deposit that a buyer makes at the beginning of a home purchase that shows that they are serious about the transaction. So, the big question when writing an offer on a home is how much should your earnest money deposit be?
Besides showing the buyer’s commitment to the transaction, earnest money serves a few other purposes. Earnest money demonstrates that the buyer does have funds readily available and they are willing to tie them up while they inspect the property and apply for their loan. Second, earnest money provides a monetary consequence that a seller can easily utilize if the buyer backs out of the purchase for no reason. This protects the seller from monetary damages incurred when a buyer breaches the contract, and keeps the resolution of these damages out of the court system. Lastly, it does prevent buyers from playing games and bidding on lots of different homes at the same time, in hopes of cherry-picking the best one.
Earnest money should not be confused with your down payment. The down payment towards your house is the amount of cash that you need to contribute towards closing the transaction. If you obtain a mortgage for 80% of your purchase price, then your down payment will be 20% of the purchase price. Earnest money is simply an initial deposit that is specified in the contract, usually much less than your entire down payment. If your home purchase closes, the earnest money deposit that you originally made will be applied towards your down payment.
So how much earnest money should you put down? There is no easy answer to this one, and deposits vary considerably depending on your local market and real estate customs. In Seattle, we typically see earnest money deposits ranging from 1%-3% of the purchase price. On a $500,000 transaction, a buyer in our market would typically make an earnest money deposit of $5,000-$10,000. Remember, the earnest money deposit is not set and is to be negotiated between the buyer and seller. Here are some recommendations when trying to determine the proper amount of earnest money.
Make it Enough to be Taken Seriously
Sellers, particularly in today’s tougher real estate market, are understandably nervous about a successful transaction. By signing a contract with you, they have to take the home off the market for 30-45 days, and they want some assurance that you are going to do what you said you were going to do in the contract. I had a buyer make a $750,000 offer on a property with $100 of earnest money. That hardly shows that the buyer is serious or financially capable of buying the home. That contract was ignored by the seller. A seller faces real economic consequences when a buyer backs out of a deal, and a serious buyer needs to be willing to show that they will risk some of their own money to compensate the seller if they get cold feet.
If you are competing with other offers, raising your earnest money is one frequently used method to entice the seller to accept your offer. With all other terms being equal, which buyer would you prefer, one with $2,000 earnest money or one with $10,000 earnest money? You can use this same technique if you are offering a low price. With some sellers, you may get them to accept a lower price if they have added assurance that you will close quickly, with minimal risk to them.
Do Not Needlessly Put Large Amounts at Risk
Most times I advise buyers to make their earnest money high enough to be accepted, but not so high that they senselessly put extra money at risk. I recently had a seller request 5% earnest money on a $575,000 purchase price. That represents a $28,750 payout to the sellers if my buyers were to back out of the transaction for no reason. Clearly the seller has not sustained $28k of monetary damages by having their home off the market for one month, so that amount is unreasonable.
When a buyer loses their earnest money, in legal terms it is referred to as liquidated damages. I am not a lawyer, and I am not familiar with the laws surrounding liquidated damages in each state, but many states have limits on the amount of liquidated damages that can be claimed in a real estate purchase. In Washington state, liquidated damages must be reasonable and just compensation for the harm caused by the breach of contract and are limited to 5% of the purchase price. You need to research what the limits are in your state, and you should definitely not be making earnest money deposits above these limits, as they become meaningless gestures.
Don’t Be Pressured by Real Estate Agents
Real estate agents representing the seller have a habit of pressuring the buyer for more earnest money than necessary. I’ve heard a variety of pitches, ranging from “Buyers in this price range ALWAYS put down 3% earnest money,” to “Our brokerage looks for 3%-5% earnest money.” Some of these requests are simply posturing as part of the negotiation, and sometimes the requests are simply a snooty request for pricier homes. It is your money, and ultimately the final amount of earnest money is a negotiation between the buyer and seller, not their agents.
Recognize the Risks
Earnest money is probably the biggest reminder of how seriously real estate contracts need to be taken. Most contracts will have a variety of contingencies that allow a buyer to walk away from the house based on unsatisfactory inspection results or the buyer’s inability to procure a loan. In the buyer backs out for legitimate reasons covered by one of these contingencies, the earnest money deposit will be returned to them. However, if you make it all the way to the end of a transaction and walk away for no legal reason, you will lose your earnest money, so you need to take the obligations spelled out in a real estate contract very seriously.
A buyer should put down enough earnest money to be taken seriously, but not a needlessly high amount, even if they have the cash available. Local market customs and amounts vary tremendously in different cities and states, so ask your real estate professional what is typical for your market.