When you’re starting your home-buying journey in a hot market like Seattle, you need to make sure you know what you’re able to do to stand out from the competition.
Taking actions such as choosing the right real estate agent, writing a convincing letter to the seller, making sure your mortgage is approved, and knowing how to find off-market homes for sale can help you get ahead in a cut-throat housing market.
Another thing that can give you a leg up when starting the process of buying (or selling) a home is an earnest money deposit.
What Is an Earnest Money Deposit?
An earnest money deposit is a transaction meant to protect both the buyer and the seller during the initial steps of securing a home purchase.
If you are a potential homebuyer and have found a home you’re seriously interested in, an earnest money deposit — also known as a good faith deposit or holding deposit — is a way to show the seller that you’re committed before closing.
Earnest money deposits are usually 1% to 3% of the total sale price of the home, although the exact amount can depend on the market. In a place like Seattle with a bustling real estate market in the seller’s favor, earnest money deposits closer to 3% are the norm, while in a slower market sellers can get away with putting down a lower amount.
These types of deposits can be considered collateral until both parties have signed a closing contract at the end of the sale, and since they aren’t required, they can be very helpful in a competitive market. If the sale goes through, a buyer’s earnest money deposit goes toward closing costs or their down payment.
The Earnest Money Transaction
In order to keep the earnest money deposit safe in the period of time before closing, the money is typically held in a third-party escrow account until the deal is complete.
In the past, paper checks were typically the preferred method of payment for both down payments and earnest money transactions for residential real estate deals.
Recently, virtual payments have been more common, especially since the virus outbreak at the beginning of 2020. Digital earnest money transaction platforms such as Earnnest and Zoccam help facilitate the secure transferring of earnest money deposit funds into an escrow account.
Another common form of earnest money transfer is through wired funds, but buyers and sellers should be wary of cyber security risks associated with this method.
How Does an Earnest Money Deposit Protect the Seller?
Earnest money deposits can be thought of as insurance to protect both the seller and the buyer during the time before the transaction has been officially completed.
In the case of the seller, the absence of an earnest money deposit can be financially disruptive to say the least.
Imagine that a potential buyer comes forward and tells the seller that they are extremely interested, and the seller takes the home off of the market to begin the closing contract process. If the buyer backs out, the seller has to relist the home and start all over again, taking a potentially huge financial hit.
In this case, an earnest money deposit would help alleviate the costliness of a buyer backing out at the last minute.
[Related: Can I Afford to Buy a Home in Seattle?]
How Does an Earnest Money Deposit Protect the Buyer?
For the buyer, putting down an earnest money deposit, especially one that’s on the larger side of the spectrum, can really make you stand out against other potential buyers in a competitive market by showing your serious intentions and literally “putting your money where your mouth is.”
Once the deal is closed, this deposit goes toward either your closing costs or your down payment, which can make the initial amount of money you end up putting down more affordable (since you paid this amount earlier in the game).
Earnest money deposits also protect the buyer by allowing them to legally back out of a real estate deal and get this deposit money back if the home falls through on a contingency. If a deal doesn’t go through because of a contingency like a failed home inspection or a buyer who couldn’t sell their existing property in time, then the earnest money deposit can be legally returned to the buyer.
A sale can only be finalized when certain contract contingencies are met. If these aren’t met at all or within a certain timeline, the earnest money deposit will either go back to the buyer or be forfeited to the property seller.
Types of contingencies in a real estate contract include:
- appraisal contingency
- mortgage contingency
- inspection contingency
- home sale contingency
Both parties are recommended against forgoing contract contingencies, even in a lightning fast market. These are meant to protect both the seller and the buyer.
Find out more about these contractual conditions and how they impact the buyer and the seller in our comprehensive Guide to Real Estate Contingencies.
Earnest Money Timeline Overview
Here’s the general timeline from expressed interest to closed sale that includes an earnest money deposit:
- A buyer expresses interest in a home.
- A purchase contract is drawn up and an earnest money deposit is placed in an escrow account.
- The seller takes the home off of the market.
- A timeline is started for things such as the house inspection or mortgage approval (as outlined in the initial contract).
- If all contingencies are met, both parties sign the contract, the sale is closed, and the buyer’s earnest money deposit goes toward closing costs or a down payment.
- The remaining balance on the home is turned into a mortgage.