A pledge or a deposit made to the seller that represents the buyer's good faith to purchase something
What is Earnest Money?
Earnest money, also known as a pledge, is a certain amount of money that a buyer pays to a seller to demonstrate his good faith and intention to complete the transaction. The amount is usually 1%-2 % of the sale price or a fixed amount.
Earnest money is also known as a binder or token money. It essentially confirms a contract and after the earnest money is paid, both the parties to the contract are under the obligation to carry forward the verbal agreement.
Often found in real estate deals, earnest money can be used to give a buyer more time to seek financing or find the remaining sum of money to cover the full price of a property. Compared to a simple deposit, earnest money is not exclusively held by the buyer but is also placed in an escrow trust or a trust account held by both sides.
Understanding Earnest Money
For buyers, earnest money serves to prove to sellers that they are serious about a certain transaction. It gives the seller an incentive to continue the transaction and wait until the buyer finds the funds to settle the full amount.
Earnest money is made as an initial prepayment in the sale process. However, if the deal falls through for any reason, the buyer may not be able to return the pledged amount.
It is especially true if the transaction is canceled through no fault of the seller. So, earnest money can be refundable or non-refundable, and the latter is usually the case.
Summary
- Earnest money is a deposit made to the seller that represents the buyer’s good faith to buy something (e.g., a home).
- Several factors affect the amount of earnest money deposit (EMD), including the current state of the real estate market, the overall price of the property, and the high demand for real estate properties.
- The EMD amount will be at least 1% of the purchase price, although, in some cases, the rates reach 2%-3%.
How It Works
Earnest money is not always paid directly to the seller. Creating an escrow account by a third-party broker helps to ensure the proper distribution of money at the end of the transaction.
As soon as the seller accepts the offer, the buyer is required to sign a contract known as a “purchase agreement.” The agreement stipulates the process of transferring the earnest money to the seller and also means that both parties are in a legally binding agreement relevant to a particular subject like a house purchase or sale.
As soon as the contract is signed, the buyer is required to make an earnest money deposit to the escrow account held by the real estate agent. When all the conditions of the purchase and sale are met, the money is paid to the seller as part of the purchase price.
However, if the buyer fails to source funds for the purchase or decides not to proceed with the transaction, he can get his money back, provided it is noted in the contract.
The concept of earnest money is based on the fact that the contract is not the buyer’s obligation to purchase the property. Many things can go wrong between an earnest money deposit (EMD) and the deal’s closure. Home inspections can detect defects that violate the deal; appraisals can be substantially low. In such cases, the buyer may have the right to take his money back or at least recover a part of it.
When a seller accepts a purchase offer, it is contractually obligated to remove the property from the market for a while until measures are taken for unforeseen circ*mstances, such as inspections and evaluations.
Earnest Money Deposit (EMD)
In many cases, the buyer can expect that the earnest money deposit amount will be at least 1% of the purchase price, although sometimes the rates reach 2%-3%. Below are some of the factors that affect the EMD amount:
- The current state of the real estate market. If homes sell quickly, a seller may require a higher EMD amount.
- The overall property values
- If more than one buyer has placed a bid on a property, the bidder offering the highest amount of earnest money might secure the agreement.
Earnest Money vs.Downpayment
The amount of money paid to a seller upfront when a property is bought is called downpayment. When a buyer pays earnest money, it shows intent to purchase a house, whereas a downpayment is usually paid after a contractual agreement is signed, and the purchase is on its way to being completed.
A downpayment of usually 20% must be produced by the buyer for the lender to approve the loan on the house. The remaining amount is usually financed by a bank. In a nutshell, an earnest money deposit is a promise to the seller of the property, and a downpayment is a promise to the lender.
More Resources
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
FAQs
With this in mind, most buyers will put down between $500 to $2,000 of earnest money on an MLS-listed property. However, in particularly hot seller's markets, it's not uncommon for buyers to put down far more to demonstrate that they're serious about a purchase.
Is $1000 enough for an earnest money deposit? ›
How Much Earnest Money Should I Put Down? The short answer is, you usually need 1–3% of the price you and the seller agree upon. But that isn't always the case. In some markets, you'll need a fixed amount—like $1,000 or $5,000.
What is the best way to explain earnest money? ›
When you find a home and enter into a purchase contract, the seller may withdraw the house from the market. Earnest money, or good faith deposit, is a sum of money you put down to demonstrate your seriousness about buying a home. In most cases, earnest money acts as a deposit on the property you're looking to buy.
Why would someone ask for more earnest money? ›
Sellers need to sell their homes quickly, so they price them competitively. Knowing there could be multiple offers for this property, a buyer offers slightly more than the asking price and offers a higher-than-standard earnest money deposit to incentivize the seller to accept their offer.
Who keeps earnest money if a deal falls through? ›
The purpose of earnest money is to provide the seller with compensation in the event that the buyer backs out of the deal through no fault of the seller and in violation of the agreements in the purchase contract. If that happens, the seller gets to keep the earnest money.
Should I walk away from earnest money? ›
Backing out of an offer for a non-contingent reason means you risk losing your earnest money. Since you put that money down based on the promise that you would follow through with the contract, backing out for any reason that's not outlined in the agreement means the seller is legally permitted to keep your money.
What happens to earnest money if a deal falls through? ›
Generally earnest money in a real estate transaction is only forfeited by the potential buyer if the reason the transaction failed is due to some reason for which the buyer was responsible; namely, failing to follow through with purchase.
Is earnest money negotiable? ›
The amount of earnest money varies and is negotiable, but usually falls between 1% and 2% of the purchase price. In competitive markets, sellers might request more than that. Here's how earnest money deposits typically work: The buyer delivers the earnest money when entering into a purchase agreement with the seller.
Does the amount of earnest money matter? ›
The amount of earnest money may depend on the particular real estate market your desired property is in. A languishing real estate listing in a slow market may not need as much earnest money as in a hot market with multiple buyers who are vying for the same property.
Who gets earnest money when buyers back out? ›
The earnest money typically goes towards the buyer's down payment or closing costs. It is refunded to the buyer only upon certain contingencies specified in the contract. If the buyer cancels the contract outside of the contingencies, it is released to the seller.
It's the difference between the purchase price and your mortgage amount, which is the amount you're borrowing. This is usually somewhere between 3% and 20% of the purchase price. Earnest money is put into an escrow account and held there until closing. It's then applied to your down payment.
How to avoid paying earnest money? ›
Earnest money deposit is NOT required on a Real Estate Purchase and Sale Agreement in any of the United States of America. The promise to buy is the consideration that's required to make the contract enforceable. To avoid the topic, you can completely removed the EMD line item from your contract.
Why do sellers care about earnest money? ›
The earnest money deposit, or good faith deposit, can protect the home seller in the event that the buyer walks away from the deal and the seller has to re-list the property and make up for lost time and effort to sell the home.
How does earnest money get refunded? ›
Earnest money is refundable in certain cases but refund of the earnest money if you back out of the contract is not common. As a buyer you would receive the earnest money deposit back if the seller causes the deal to fall through.
Is earnest money the same as down payment? ›
While many inexperienced home buyers think that this is the down payment, it really isn't. The earnest money deposit is made along with your offer to show the buyer that you are a serious buyer and goes TOWARDS your down payment. The down payment, of course, is much larger and comes at the time of closing.
Is 5% earnest money too much? ›
Usually, it ranges between 1-10% of the home's sale price. While earnest money doesn't obligate a buyer to purchase a home, it does require the seller to take the property off of the market during the appraisal process. Earnest money is deposited to represent good faith in purchasing the home.
Can earnest money be negotiated? ›
The amount of earnest money varies and is negotiable, but usually falls between 1% and 2% of the purchase price. In competitive markets, sellers might request more than that. Here's how earnest money deposits typically work: The buyer delivers the earnest money when entering into a purchase agreement with the seller.
