Earnest Money Demystified

What exactly is earnest money? This seems to be a question that is front of mind for a lot of first time home buyers.  The simple answer is this: Earnest money is a check presented to the sellers (usually within 2 days of mutual acceptance) that shows you are serious about buying the home.  The earnest money is most often a personal check and is for an amount of 1% – 3% of the purchase price.

Why?  The earnest money has several functions.  It shows the seller that you are serious about buying the property.  It also provides the seller with a promise of funds (the amount of the earnest money that does not exceed 5% of the purchase price) should the buyer default on the purchase.  Stated simply, if the buyer does not go through with the purchase of the home for reasons that are not covered by contingencies in the purchase and sale agreement, the seller gets to keep the earnest money.

Real life example:

Doug and Daisy put in an offer on a $300,000 home.  They love the home and want to make the best possible impression on the seller.  With the purchase and sale documents, they offer the seller $8,000 earnest money.  Once the buyers and sellers come to a final agreement on the terms of the purchase (called mutual acceptance), the buyer gives the earnest money check to the closing agent and the check is deposited into an account with Escrow.

IF: Everything goes smoothly, and Doug and Daisy buy the house.  The $8,000 earnest money check is applied to the amount they need for the down payment and the house becomes theirs.

IF: Doug and Daisy decide, three days before closing, that they don’t want to buy the house and are going to pull out of the deal at the last minute.  Since they are contractually obligated to buy the house at this point, they lose their earnest money.  The seller keeps the $8,000 earnest money check and puts the house back on the market.

Buyers are often fearful that they will somehow “lose” the earnest money.  In most contracts, the buyer has several contingencies (such as an inspection) that allow them to back out of the contract without forfeiting the earnest money.  The earnest money is only kept by the seller if the buyer fails to complete the transaction under all terms of the contract.

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