What is Earnest Money and What is it Used For?

Earnest money protects the interests of both parties in a property sale transaction. The buyer makes the payment and uses it to formally make an offer to the seller.

It is a common practice in the real estate industry. However, you should carefully protect this money as a breach of contract may result in a forfeiture of this amount.

Let us guide you on what earnest money is, why you should pay it, and how to protect it.

What is Earnest Money?

Earnest money is an upfront payment that buyers pay along with an offer to buy a property. It is also called “good faith money,” “good faith deposit” or simply “deposit.”

At the time of making an offer, this amount paid to the seller is placed in an escrow account. It means neither the seller nor the buyer can use this money until the deal is finalized.

There are no legal restrictions to paying earnest money and there are no standard rules on how much a buyer should pay as earnest money.

As the alternate name suggests, earnest money shows the good faith of the buyer when making an offer. It can later be included in the total purchase price of the property when the contract is formally signed by both parties.

Where Earnest Money is Used?

Earnest money is commonly used in the real estate sector. It is used for buying residential and commercial properties in good faith or depositing money by buyers.

When a buyer shows interest in a property or house, she (he) makes a formal offer to the seller. If the seller agrees on the price, the buyer proceeds to arrange the finances.

However, during this time the seller may receive another offer from somewhere else. This way, the first buyer could potentially lose the chance to buy that property.

Similarly, the seller may wait endlessly if the buyers change their minds after making an offer. The earnest money bridges this confidence gap between a seller and buyer.

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The earnest is then deposited into an escrow account managed by a broker or mortgage company. The money stays in an escrow account until the deal is finalized and the buyer makes a down payment.

Depending on the contract terms, the earnest money becomes part of the down payment and hence the total price of the property.

How Much Do You Need to Pay Earnest Money?

There are no standard rules on how much earnest money should you pay. It depends on different factors.

When the mortgage economy is down, sellers would ask for a fraction of the total property price as earnest money. During a crunch housing time, it would usually range between 1-3%.

When the mortgage economy is booming, sellers would get more offers than usual. It means they would demand a higher proportion of the house price as the earnest money ranges between 5-10%.

Sometimes, the sellers would ask for a fixed amount like $5,000 or $10,000 as good faith money. In other cases, sellers may demand more than one payment during the due diligence period to keep the buyer’s faith in the deal.

When Earnest Money is Refundable?

The earnest money is usually refundable. As a common practice, it is included in the down payment when both parties sign the agreement formally.

Then, the buyer will get the earnest money back if the seller backs out of the deal or there are contingencies in the contract.

So, a buyer is safer if the terms and conditions of the earnest money are duly agreed upon at the time of making an offer.

Some conditions when a buyer gets the earnest money back include:

  • When the seller cannot sell the property or the title of the property is different.
  • If the buyer is unable to secure a mortgage deal (finances).
  • The due diligence reveals one or more significant damages to the property.
  • The due diligence shows a lower property price and the seller refuses to renegotiate the price.
  • If the seller does not agree to pay the cost or arrange repairs as outlined in the initial offer.
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In a nutshell, if the fault is from the seller’s side, the buyer will get back the earnest money.

When You Can Lose Earnest Money?

As a buyer, you may have to forfeit the earnest money if you don’t fulfill your obligations as outlined in the initial offer.

The most common reason for losing earnest money is not following the contract deadlines for arranging finances. You can contact the seller or the mortgage broker to get more time.

Also, you must deposit the required down payment by the deadline. Again, if you fail to do so, the seller has the right to forfeit your good-faith money.

Then, if you didn’t include the terms and conditions of due diligence or contingencies in the initial offer, the seller would hold your good faith deposit.

In short, if the fault lies on the buyer’s side, the earnest money will be forfeited by the seller.

How to Protect Your Earnest Money?

Protecting your earnest money requires careful planning when making an offer to a prospective seller.

Follow these tips to save your deposit money:

  • Take time to investigate the seller or mortgage broker. Always deal with licensed and regulated mortgage brokers.
  • Put everything in writing about the earnest money, down payment, mortgage financing, and contingencies to legally safeguard your interest. Seek professional help here for perfect results.
  • Take time to understand the clauses of the offer and the purchase agreement including those for contingencies and due diligence on the property.
  • Always make the payment through secured payment instruments like money order, certified check, or wire transfer.
  • Always deposit the money into an escrow account and avoid paying in cash.
  • Follow the terms and conditions of the contract and be mindful of the deadlines. If you need more time, contact the seller.
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Earnest Money Vs. Down Payment

As a buyer, you pay the earnest money to a seller or mortgage broker to show good faith in the offer you make for a property.

The down payment is made to the lender when you close the mortgage deal for the property. So, the basic difference here is the receiver of the money.

Then, the earnest money is usually much smaller than the down payment. Buyers can choose to pay anything above the threshold down payment amount to reduce their mortgage amount.

Basically, the earnest money is a demand from the seller, and a down payment is required by the lender, both from the buyer. The former secures your initial offer for the house while the latter close your mortgage deal with the lender.

Should You Pay Earnest Money?

As mentioned above, paying earnest money is not a legal obligation. However, due to increased competition in the mortgage market, it has become standard practice.

A seller will take your offer more seriously when you pay the good faith deposit as compared to a prospective buyer who makes an oral offer.

Keep in mind, if you change your mind after depositing good faith deposit, the seller has the right to keep that money. Unless the seller returns the money to you in good faith, you cannot claim it legally.

So, you should only pay the earnest money when you’ve done the homework. Also, follow the tips outlined above to protect your good faith deposit and make it a smooth experience for both parties.