The Merriam-Webster Dictionary defines “earnest” as a serious and intent mental state or a considerable and impressive degree. Similarly, synonyms-thesaurus.com shows that synonyms for earnest include ardent, sincere, sober, and purposeful. From these clues, we can discern that “earnest money” is a means for demonstrating serious intent and sincerity. Typically, a potential buyer pays earnest money to a seller to indicate that their offer to purchase property is in good faith. From the seller's perspective, receiving earnest money provides some assurance that the prospective buyer won’t abandon the transaction without cause.
How much earnest money is customary?
There are no rules, but one percent of the purchase price is a typical offer for earnest money. Of course, in a hot market, sellers may ask for more. The earnest money deposit stays in escrow while negotiations continue, including any requested inspections and appraisals. The time may also include the opportunity for the buyer to solidify financing. In deals that end with a completed purchase, the earnest money typically becomes part of the down payment.
While earnest money is nearly always expected in residential transactions, it's not always part of a commercial deal. Whether it is requested and how much is necessary depends on the market conditions.
What happens if the deal falls apart?
In many cases, the earnest money deposit is refundable, but it depends on why the transaction has failed and the contract terms. Usually, the deal will include deadlines for inspections, appraisals, and financing, so the seller isn't waiting with no agreement forthcoming but still giving the buyer adequate time to complete the tasks. If the buyer can’t get financing, they may have to forfeit the earnest money deposit unless the contract specifically states otherwise. On the other hand, if the seller backs out of the deal or there is an issue uncovered in an inspection, the funds will usually be returned to the prospective buyer.
Where should the money be held?
Escrow is the best place to hold earnest money and any other funds that need to be deposited during a real estate transaction. Escrow funds are typically overseen by a title company or sometimes an attorney. The escrow agent is the custodian of the money and only releases them after each side has met their contractual obligations. The agent can return the earnest money to the potential buyer if the sale falls through or to the seller if the buyer backs out. However, if the deal is executed successfully, the agent will apply the escrow funds toward the purchase price or closing costs, depending on the terms of the deal.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.