What Is Good Faith Money?
Good faith money is a deposit of money into an account by a buyer to show that he or she has the intention of completing a deal. Good faith money is often later applied to the purchase, but may be nonrefundable if the deal does not go through.
- Good faith money acts as a security deposit towards completing a purchase.
- This payment is usually nonrefundable, but credited towards the purchase.
- When the seller wants to both qualify and motivate a buyer, the deposit amount asked for will be larger.
- Both seller and buyer should specify good faith money terms in writing.
Understanding Good Faith Money
Good faith money can also be known as earnest money, and acts similar to a security deposit. Where a security deposit for a rental vehicle or equipment may be taken as insurance against damages, good faith money is usually taken as an insurance against lost opportunity should the buyer not go through with completing a purchase.
In most cases, the deposit amount will be a percentage of the total amount owed, 5% or less for something large like a house or lease contract, and 25% or less for smaller purchases of consumable items . A common example of good faith money is the so-called "earnest money" escrow deposit required by most home sellers to enter into a sales contract with a buyer.
The amount of good faith money used to initiate a contract with a seller will vary considerably depending on the asset, the local market, and the credibility of the buyer. For example, when the housing market in a given locale is very hot and multiple buyers make offers on the same properties, the expected earnest money deposit, in some areas, can rise to 5-10% of the potential purchase price of the home. In expensive neighborhoods this can be such a substantial amount that the buyer has much more incentive to merely make the purchase, rather than delay while working out financing. Those buyers who do not have financing available already are thus weeded out in favor of buyers with stronger financial footing.
This phenomenon reflects the fact that although the money is ostensibly for the seller to offset the opportunity cost of doing business with a different buyer, the higher demand allows the seller to command more earnest money, pushing the buyer to quickly make a decision right away. This also creates a sunk-cost bias in the buyers which may help them get past their buyer's remorse if they bid up the property too high. Either way a large earnest money requirement works in favor of the seller and should be a bit of a warning sign that they are about to pay an extra premium for the property. For someone who is looking to make a shrewd purchase this would be a warning sign to let the property go.
Most good faith money deposits are part of an agreement that spells out the conditions under which a buyer may lose their deposit if they are unable or unwilling to complete the contract. The written agreement is important for the buyer to insure that the deposit will actually go towards the purchase.
A good faith deposit may seem a little like a call option because the buyer has the right to complete the ultimate purchase. However, unlike an option, good faith money is usually applied to the final purchase price, while a call option premium is not.