Everything You Need to Know About Earnest Money

There are a litany of fees and hidden costs associated with the homebuying process — and preparing for those costs is an important part of budgeting to buy a home. The earnest money deposit, also known as a good faith deposit, is one such cost. Paying it could mean the difference between having your offer accepted or rejected.

But what exactly is it — and most importantly, when can you lose that money as a buyer?

When you officially put an offer on a house, you have to show the seller that you're serious about purchasing the property. One way to do that is to include a certain amount of money with the offer. This is known as the earnest money deposit, and it is used to secure your offer. It also shows good faith that you want this home purchase to be completed (hence the nickname "good faith" deposit).

Earnest money is usually a percentage of the asking price — generally between 1 percent and 3 percent, but it isn't necessarily a fixed amount. For instance, if you buy a $200,000 house, the earnest money may be anywhere from $2,000 to $6,000. In cities with a competitive real estate market, the real estate agent may suggest offering as much as 10 percent of the sale price to set yourself apart from the other potential buyers.

Earnest money is usually paid within three days of the seller agreeing to the offer. You can pay with a personal check, a cashier's check, or a wire transfer. If you're buying a home in a different city, you may also have to pay for overnight shipping to ensure the check gets delivered on time.

If you're sending the earnest money via wire transfer, make sure the instructions are secure and accurate. There have been reports of phishing scams where a hacker pretends to be a real estate agent and sends you false wire transfer instructions. Unfortunately, in these schemes, when you send the money, it's gone forever.

Once the earnest money deposit is sent, it's held in an escrow account. The lender and seller do not have access to the money until the sale is finalized at closing. While earnest money is not mandatory, sellers are much less likely to accept an offer without it. If you can't afford to send earnest money, you may not be able to afford a home in the first place. Before sending the earnest money, make sure you actually have that much in your account.

Once the sale is finalized, the earnest money is put toward the down payment or closing costs. However, things can get complicated if the deal falls through. There are some common scenarios in which you can get back your earnest money. These contingencies (or criteria for the deal to go through) only come into play if your real estate agent has included them in your contract. Before you sign the contract, ask your agent what contingencies are included and what is recommended. These are some of the most common reasons why a homebuyer receives the earnest money back.

If the seller decides to unlist the house for any reason, the earnest money will be returned to you.

After the offer is accepted, an appraisal will be scheduled to determine the fair market value of the house. If the appraisal comes in below the offer price and the seller is unwilling to come down on the price, then you can revoke your offer and receive the earnest money.

After the offer is accepted, you will have to schedule a home inspection to see if there are any problems with the home. If the inspector finds major issues, you can ask the seller to make these repairs, negotiate a lower selling price, or refund some money at closing. If the seller refuses, you can withdraw the bid and take back your earnest money.

If you're also selling a house while buying a new one, you may add a contingency saying that you can back out and keep the earnest money if your current home doesn't sell within a certain period of time. This protects you from having to pay two mortgages at once. A buyer should be aware that this stipulation may prevent an offer from being accepted by the seller, especially if the seller can choose an offer from a buyer without this contingency.

Before closing, the title company will run a title search on the property. This will uncover any potential problems with the title, like an heir with a legal claim to the home. If there are any issues, you can withdraw the bid and take the earnest money. (It should be noted, however, that this is fairly rare.)

Shortly before closing, you're allowed a final walk-through. The seller should be moved out at this point and all agreed-upon issues should be resolved. If the seller has not held up his end of the agreement, like a promise to fix the electrical wiring or remove an outdated appliance, then you could walk away from the deal and take the earnest money with you.

If you're buying a house that comes with a homeowners' association (HOA), you're legally allowed to review the HOA documents before closing. These documents should state the HOA's rules, annual budget and any recent incidents. Many HOAs have a reputation for being nit-picky. For example, it may have limits on how many Christmas lights you can display or what kind of landscaping you can have in your front yard. If it seems like the HOA has too many rules, you may decide to back out. Most buyers get a few days to review these documents and can cancel the purchase contract during this time. If you cancel during the HOA review period, you'll get your earnest money back.

The seller is legally allowed to keep the earnest money if none of these contingencies apply. For example, if you simply have a change of heart about the house, then the seller can keep the earnest money. In many states, you have to release the earnest money but sometimes the seller can choose not to do so. In that case, the seller would have to file a lawsuit to obtain the earnest money from the escrow company. This could take months and could end up costing more than the amount of the earnest money.