Real estate transactions are major decisions, for both the buyer and the seller. Because of this, the process is not as simple as handing over a check and moving in. Once a house is under contract, several steps are completed to make sure the deal is good for both sides moving forward.
Earnest money, or good faith money, is the first of these steps. Soon after a contract has been signed, earnest money is deposited into an escrow account. An escrow account is held by a third party, typically the real estate brokerage, legal firm, or title company, on behalf of the buyer and seller. This money shows the buyer is serious about the home, and ensures the seller takes the home off the market as the process moves forward. In most markets, the earnest deposit is between 1% and 3% of the home price.
Once earnest money is deposited, both the inspection and appraisal are completed. When the deal makes it to closing, earnest money is applied to the down payment or closing costs. If the buyer backs out of the deal, contingencies in the contract will determine whether or not the earnest money is returned. In most cases, if there are issues with inspection or the seller backs out, earnest money is given back to the buyer after a cancellation fee is taken out.
Essentially, earnest money means the buyer is ready to move forward with the purchase based on what they currently know about the home. It is important to read through the purchase agreement before signing to know what circumstances will return the money should the deal fall through.