Earnest Money

What is 'Earnest Money'

Earnest money is a deposit made to a seller showing the buyer's good faith in a transaction. Often used in real estate transactions, earnest money allows the buyer additional time when seeking financing. Earnest money is typically held jointly by the seller and buyer in a trust or escrow account.

Earnest money is also known as a Good Faith Money.

BREAKING DOWN 'Earnest Money'

When a buyer decides to purchase a home from a seller, both parties enter into a contract stipulating the final sale price of the house and the down payment. The contract does not 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 that the seller takes the house off the market while the house is inspected and appraised. To prove to the seller that the buyer’s offer to purchase a property is earnest or in good faith, the buyer will be required to make an earnest payment as a deposit.

Earnest Money and Contracts

The earnest money paid is put toward the buyer's down payment when the transaction is finalized. The transaction is usually finalized after inspections are done and the buyer secures a mortgage with the bank. If the deal falls through, the buyer may or may not be able to reclaim his or her earnest money, depending on how the contract is phrased. If the contract stipulates that the buyer must have appraised the home by a certain deadline, and this does not happen within the specified timeframe, the buyer will probably not be refunded his earnest money. If the buyer decides not to go through with the house purchase for contingencies not listed in the contract agreement, he is most likely to lose the earnest money deposited. The earnest money is retained by the seller to protect the seller from any monetary damages incurred from the broken contract and to keep the resolution of damages out of court. The buyer is likely to get his full earnest deposit back if a failed contingency, such as poor results from an inspection, ensues. Also, if the seller terminates the deal, the earnest money will be returned to the buyer.

Characteristics of Earnest Money Payments

The amount of earnest money to be paid varies from city to city and is to be paid within 1 to 3 days after the seller accepts the buyer’s offer. In Seattle, for example, the earnest money deposit lies in the range of 1% to 3% of the sale price of the property. This means that a property selling for $400,000 will require an earnest deposit between $4,000 and $12,000, as negotiated between the buyer and seller. In addition to the local market rates, the amount of earnest money also depends on the level of interest other buyers have expressed, how hot the housing market in the area is, and how quickly a prospective buyer can close on his or her offering price. In some areas with hot housing markets, the earnest money deposit can be between 5% to 10% of a property's sale price. Some sellers set fixed amounts on earnest money instead of going with a percentage of sale price or down payment. The fixed amount set by sellers usually fall within the range of $5,000 to $10,000. Of course, the higher the earnest money, the more serious the seller is likely to consider the buyer. Therefore, a buyer should ensure to offer a high enough earnest deposit to be accepted, but not too high as to put extra money at risk since there is still a chance that the deal might not go through and the deposit not refunded.

Earnest money is usually paid by certified check, personal check, or a wire transfer into a trust or escrow account which is held by a real estate brokerage, legal firm, or title company. The funds will be held in the account until the sale of the home has been finalized. At this point, the earnest funds are applied toward the buyer’s down payment. It is important to note that escrow accounts, like any other bank account, can earn interest. Therefore, if the earnest funds in the escrow account earn interest of more than $5,000, the buyer will have to fill out tax form W-9 with the IRS to receive the interest.