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When you buy real estate, it’s very exciting. First, you shop until you find your dream home (or maybe your dream home minus some bedrooms and closets). Then, you write possibly the biggest check of your life.

What is it? What happens to it?

It’s Not Actually a “Down Payment”

Because it’s the first money that a buyer puts “down” against the purchase, buyers often refer to it in slang as the “down payment.” That’s not technically correct, mostly because a purchase might involve more money down later. For example, you might buy a $400,000 house and hand over 5 percent of the purchase price (or $20,000), when you sign the contract, and then put another percent down at closing, so that your entire down payment is $40,000, in addition to the fact that you’re handing the seller a mortgage for the last 90 percent.

[Related: Read The Fine Print: Understanding Real Estate Contracts]

How to Handle That “Earnest Money”

So technically, that check that goes with the contract is known in the trade as “earnest money” (because it’s used to prove that you’re very, very earnest about buying this property) or the “contract deposit.” You don’t, however, want to just hand it over. It should go into a special account, known as an escrow account, which is held by the seller’s lawyer.

Where Does the Money Go?

It varies by state. In my state, real estate contracts even have a special clause to tell you what bank the seller’s lawyer is using to hold the escrow. In California, all the other money in a real estate transaction, even the mortgage, goes through escrow, too (but that’s not the way it is in most states). More typical is that the earnest money stays in escrow until the deal closes — and you own the house or apartment.

[Related: How Banks Decide How Much to Lend You]

If Something Goes Wrong, Do You Get Your Money Back?

Well, that depends on the terms of your contract. Your contract — which you should read carefully, even if you are also hiring a lawyer to read it — should outline in what scenarios your earnest money is forfeited, and in what scenarios you would get it back.

Typically, you might get it back if:

  • the seller changes his or her mind and decides not to sell
  • you have a contract with a financing contingency, and the bank denies you a mortgage loan
  • you have a contract with an inspection contingency, and the inspector finds something seriously wrong (like a terrible termite infestation) with the subject property
  • there is a fire in the property before you buy
  • you elect to cancel the contract rather than go through with the deal

The most typical reason not to get your money back:

  • you, as the buyer, change your mind and decide not to buy.

In other words, you can’t just cancel your contract on a whim. There are probably secondary provisions that keep you from “throwing” the deal — for example, if you have a financing contingency, then you wouldn’t have to go through with the purchase if the bank doesn’t give you a mortgage loan. But, there are probably contract provisions that state that you have to apply seriously and give the bank the income documentation and financial records that it asks for.

The NC Realtors “Realtor Report” cites a case where the buyer thought she was getting an FHA loan, and then found out that the FHA wouldn’t finance in the condo building where she was trying to buy. You might think that’s not her fault, but she still lost her deposit because she didn’t do enough research.

So, (I said this above but it bears repeating) read your contract. The huge amount of money you save may be your own.

More from LearnVest:

How much cash should you hold in reserve?  What’s a Good Margin of Safety?

Need to figure out how much house you can afford? Consider Your Monthly Cost of Living

Thinking of buying? Five Tips For Prospective Buyers

This post originally appeared on LearnVest.com on May 25, 2011 and was written by Alison Rogers. It is republished here with permission from LearnVest.

Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Zillow.

About the Author

LearnVest is here to empower you to take control of your personal finances so that you can live your richest life. We have the information, tools and financial experts you need to have a healthy financial life now and an even brighter future.

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