Earnest Money: Definition and How It Works in Real Estate

What Is Earnest Money?

Earnest money is a deposit made to a seller that represents a buyer's good faith to make a purchase such as the acquisition of a new home. In many ways, earnest money can be considered a deposit on a home, an escrow deposit, or good faith money.

Understanding Earnest Money

In most cases, earnest money is delivered when the sales contract or purchase agreement is signed, but it can also be attached to the offer. Once deposited, the funds are typically held in an escrow account until closing, at which time the deposit is applied to the buyer's down payment and closing costs. The money gives the buyer extra time to get financing and conduct the title search, property appraisal, and inspections before closing.

When a buyer decides to purchase a home from a seller, both parties enter into a contract. The contract doesn't obligate the buyer to purchase the home, because reports from the home appraisal and inspection may later reveal problems with the house. The contract does, however, ensure the seller takes the house off the market while it's inspected and appraised. To prove the buyer's offer to purchase the property is made in good faith, the buyer makes an earnest money deposit (EMD).

The buyer might be able to reclaim the earnest money deposit if something that was specified ahead of time in the contract goes wrong. For instance, the earnest money would be returned if the house doesn't appraise for the sales price or the inspection reveals a serious defect—provided these contingencies are listed in the contract.

How Much Are the Earnest Money Amounts?

While the buyer and seller can negotiate the earnest money deposit, it often ranges between 1% and 2% of the home's purchase price, depending on the market. In hot housing markets, the earnest money deposit might range between 5% and 10% of a property's sale price.

While the earnest money deposit is often a percentage of the sales price, some sellers prefer a fixed amount, such as $5,000 or $10,000. Of course, the higher the earnest money amount, the more serious the seller is likely to consider the buyer. Therefore, a buyer should offer a high enough earnest deposit to be accepted, but not one so high as to put extra money at risk.

A seller may also require ongoing, periodic earnest deposits to have a prospective buyer continue to show good faith during their due diligence process. For example, a seller may require a buyer to make monthly earnest deposits on a fixed schedule over a three month due diligence period. Should the buyer fail to meet any earnest money deposit requirements, the seller may be entitled to bring the property back to market and potentially recover losses via keeping portions of the earnest money.

How Is Earnest Money Paid?

Earnest money is usually paid by certified check, personal check, or a wire transfer into a trust or escrow account that is held by a real estate brokerage, legal firm, or title company. The funds are held in the account until closing, when they are applied toward the buyer's down payment and closing costs.

It's important to note that escrow accounts, like any other bank account, can earn interest. If the earnest funds in the escrow account earn interest of more than $600, the buyer must fill out tax form W-9 with the IRS to receive the interest.

Is Earnest Money Refundable?

Earnest money isn't always refundable. The good news for buyers is in most situations, as long as a buyer acts in good faith, earnest money is refundable. As long as any contract agreements are not broken or decision deadlines are met, buyers usually get their earnest money back. Specific conditions where buyers often get their earnest money back include:

• If a home inspection reveals there are material issues with a property being sold. The buyer can usually choose to negotiate who is responsible for the repairs or can back out of the purchase.
• If a home appraises for lower value than the agreed purchase price. The buyer can negotiate a lower purchase price or can back out of the purchase price.
• If a buyer is unable to sell their current house (as long as this home sale contingency is agreed upon).
• If a buyer is unable to obtain a loan/financing (as long as this funding contingency is agreed upon).

Every situation is different, but broadly speaking, the seller gets to keep the earnest money if the buyer decides not to go through with the home purchase for reasons not specified as part of the contract. For example, if a buyer simply has a change of heart decides not to buy the property, the seller is most likely entitled to retain earnest money proceeds.

Protecting Your Earnest Money Deposit

Prospective buyers can do several things to protect their earnest money deposits.

• Make sure contingencies for financing and inspections are included in the contract. Without these, the deposit could be forfeited if the buyer can't get financing or a serious defect is found during the inspection.
• Ensure contract terms are in writing. The contract agreement between a buyer and seller should be in writing. This clarifies any misunderstandings and sets the precedence for terms of the agreement. Amendments to the contract are always allowable, but ensure that every iteration of the agreement is in writing and signed by both parties.
• Read, understand, and abide by the terms of the contract. For example, if the contract states the home inspection must be completed by a certain date, the buyer must meet that deadline or risk losing the deposit—and the house.
• Utilize an escrow account to hold funds. Do not send escrow money directly to the seller; if the funds are in direct possession by the other party, they can control the funds and not release funds even if you are entitled to earnest money refunds.
• Make sure the deposit is handled appropriately. The deposit should be payable to a reputable third party, such as a well-known real estate brokerage, escrow company, title company, or legal firm (never give the deposit directly to the seller). Buyers should verify the funds will be held in an escrow account and always obtain a receipt. 

Earnest Money vs. Down Payment

Earnest money and down payments are both used in real estate transactions, yet they serve different purposes. Earnest money is a sum of money provided by the buyer to prove seriousness. On the other hand, a down payment is usually a larger sum of money paid by the buyer at the time of closing to secure financing for the purchase of the property.

Unlike earnest money, which is more of a gesture of commitment, the down payment represents a portion of the total purchase price and is required by lenders as a form of collateral. The size of the down payment is determined by various factors including the type of mortgage, the lender's requirements, and the buyer's financial situation. For instance, for transactions where the seller has more risk, they may require a higher down payment (i.e. 20% of the acquisition price as opposed to 10%).

The down payment reduces the amount of money that needs to be borrowed, thereby lowering the loan-to-value ratio and potentially improving the terms of any mortgage. While earnest money could be applied as a down payment, it is usually returned to the buyer as part of the transaction as it initially never represented a portion of the purchase price.

Example of Earnest Money

Suppose Tom wants to buy a home worth $100,000 from Joy. To facilitate the transaction, the broker arranges to deposit $10,000 as a deposit in an escrow account. The terms of the subsequent agreement signed by both parties state that Joy, who is currently living in the home, will move out of it within the next six months.

However, Joy is unable to find another place of residence by moving day. As a result, Tom cancels the transaction and gets his deposit money back. The deposit money has earned interest of $500 from the escrow account during this time period. Since the amount is less than $600, Tom is not required to fill out an IRS form to retrieve the amount.

The Bottom Line

When a buyer and seller enter into an initial agreement to transfer ownership right of property, the buyer is often required to make a deposit of earnest money into an escrow account. There's a number of reasons the buyer and seller can agree to where the buyer can back out of the agreement. However, should the buyer break contract or not meet required deadlines, the seller may be entitled to keep the earnest money as compensation for the break of good faith.