Buying a Home → Before You Buy
Earnest Money: What & How Much?
Earnest money can be one of the most misinterpreted subjects of a real estate transaction. Both buyers and sellers often misunderstand the purpose of earnest money, and many court battles have been waged over it.
The first and most important quality of earnest money that needs defining is who owns it.
Earnest money is typically a deposit to escrow of good faith from the buyer that they will abide by contract terms while seeking to purchase a property from a seller. The deposit must be delivered immediately (within two days) to escrow or the buyer’s agent after mutual acceptance is created.
The seller will in turn remove the property from the market while the buyer works through the purchase process which may include inspections, seeking financing, appraisal, and so on. Earnest money remains the property of the buyer while in escrow, but the buyer could potentially lose it to the seller due to default on the purchase contract or when the purchase closes. (Note: Not all defaults by buyers lead to loss of earnest money, and earnest money is often refunded during closing if there’s no required cash to close from the buyer.)
So what constitutes default of contract by the buyer?
Oftentimes, it’s clear and straightforward such as a buyer simply walking away from the transaction a day before closing. Other times it’s not so clear and lawyers often get involved. As a buyer, it’s important to remember that purchase contracts are very complicated with many detailed requirements and overlapping timelines. It is both the buyer’s and their agent’s responsibility to stay in compliance with the contract. The importance of picking a diligent and experienced buyer’s agent might seem all the more significant now.
We’ve discussed how to lose earnest money, but what happens if a buyer terminates the contract through the terms set forth within it? Does the buyer lose their earnest money?
The short answer is no, the money is refunded to the buyer. The long answer is still possibly if the buyer has previously defaulted on the contract and the seller still has rights to those funds after termination.
Complicated yet? If the buyer has not defaulted on any contract terms and terminates under one of their protected terms such as financing, inspection, appraisal or a contingent purchase, then the earnest money shall be refunded to them. But if a buyer has defaulted on the contract (and unless it is outlined that the contract must then terminate), the seller may often still pursue closing with that buyer and retain right to the earnest money in case of any other termination whether legitimate or not.
Lastly, what is an acceptable amount to offer and how can it be leveraged to create a competing offer?
Typically, sellers prefer to see earnest money amounts between 1 and 2% of the purchase price. The more a buyer offers up, the more skin they have in the game. In turn, a buyer can increase the desirability of their contract by offering a higher earnest money amount. Higher earnest money amounts offer the seller more compensation if the buyer defaults and the property’s time spent removed from the market is lost. Higher earnest money amounts also indicate to the seller a higher devotion to the purchase.
A disagreement of earnest money is not something either party wants within a transaction, but it often happens. Buyer’s must understand the importance of a diligent agent to keep them on track and out of hot water.