What Happens to Earnest Money in a Real Estate Deal?

Earnest money serves as a demonstration of a homebuyer’s serious intent in a real estate transaction. This financial deposit signals to the seller that the buyer is committed to proceeding with the purchase, distinguishing their offer from less serious inquiries. It helps assure the seller that their property will not be taken off the market frivolously. The concept of earnest money is fundamental to establishing trust and commitment between parties in a real estate agreement.

Defining Earnest Money

Earnest money is a sum a buyer provides to show good-faith intention to purchase a property. This deposit is made after the seller accepts the buyer’s offer, solidifying the buyer’s commitment to the contract. While not always mandatory, it is a customary practice, especially in competitive markets, as sellers often prefer offers that include this deposit.

The amount of earnest money is negotiable between the buyer and seller, but it commonly ranges from 1% to 3% of the home’s purchase price. For instance, a $300,000 home might involve an earnest money deposit between $3,000 and $9,000. In highly competitive markets, a higher percentage, sometimes up to 5% or even 10%, might be offered to make a bid more attractive.

Once deposited, the funds are held by a neutral third party, such as an escrow agent, title company, or real estate broker, in an escrow account. This arrangement protects both the buyer and seller by ensuring neither party has direct access to the funds until specific conditions of the contract are met or the deal is terminated. The purchase contract outlines who holds the earnest money and the conditions for its release.

Earnest Money in a Closed Deal

When a real estate transaction closes, the earnest money deposit is applied towards the buyer’s financial obligations at closing. The funds are credited towards the buyer’s down payment, closing costs, or a combination of both.

For example, if a buyer’s earnest money was $5,000 and their down payment is $20,000, the earnest money reduces the amount needed at closing to $15,000. This credit is reflected on the closing disclosure document and becomes part of the buyer’s contribution to the property purchase.

Earnest Money in a Failed Deal

If a real estate transaction does not close, the earnest money’s fate depends on the purchase contract and the reason for the deal’s failure. The contract includes specific conditions, known as contingencies, which protect the buyer’s earnest money. If the contract is terminated due to the failure of one of these valid contingencies, the buyer is entitled to a full refund.

Common contingencies include:
Financing contingency: Allows a buyer to back out and reclaim their deposit if unable to secure a mortgage loan.
Inspection contingency: Provides an escape if a home inspection reveals significant issues that cannot be resolved.
Appraisal contingency: Protects the buyer if the home appraises for less than the agreed-upon price, allowing renegotiation or withdrawal.
Clear title contingency: Ensures the buyer can receive their money back if the seller cannot provide a clear property title.

Earnest money may be forfeited to the seller if the buyer defaults on the contract without a valid contingency. This occurs if a buyer changes their mind, fails to meet deadlines, or breaches the agreement for reasons not covered by a contingency. In such cases, the earnest money serves as liquidated damages for the seller, compensating them for the time the property was off the market.

The release of earnest money in a failed deal requires a mutual release form signed by both buyer and seller. This document instructs the escrow agent to disburse funds. If a dispute arises and parties cannot agree on who is entitled to the funds, the escrow holder keeps funds in the escrow account until resolved. Resolution may involve negotiation, mediation, or arbitration, where a neutral third party helps the parties reach an agreement. If these methods fail, the escrow agent may initiate an interpleader action, a legal process where funds are deposited with a court for determination.