Buying a home is a major financial decision. When a buyer finds a property they want to purchase, they need a way to show the seller that they are serious. This is where earnest money becomes important.
Earnest money is a deposit a buyer makes when they submit an offer on a home. It shows that they intend to follow through with the transaction. If the sale closes, this deposit usually becomes part of the down payment or closing costs. If the deal falls through for a valid reason, the buyer might get the deposit back.
In this article, you will learn what earnest money means, how it works, its types, its history, and its importance in real estate.
What is Earnest Money?
Earnest money is a financial deposit a buyer provides to a seller when making an offer on a property. People often call it a “good faith deposit.” It signals the buyer’s intention to complete the purchase agreement.
This money is not an extra charge. Instead, it goes toward the total purchase price if the deal closes. Buyers usually deposit this money into an escrow account. This neutral third party holds the money until the closing process ends.
Earnest money is different from the down payment. It happens earlier in the process and helps build trust between both parties.
Breaking Down Earnest Money
To understand this concept better, consider the following elements:
- Deposit amount: This usually ranges from 1% to 3% of the home’s purchase price. However, some markets may require a higher or lower amount.
- Escrow account: A third-party service holds the said money. This ensures fairness for both the buyer and the seller.
- Contingencies: The contract may include certain conditions. These could involve passing a home inspection or securing financing. If the buyer meets these conditions and the deal still fails, they may get their money back.
Example: A buyer offers $350,000 for a home and includes a $7,000 earnest money deposit. If the transaction moves forward, this deposit will apply to their closing costs. If the inspection reveals serious damage and the buyer backs out, the seller may refund the money depending on the contract.
History
Earnest money has a long history in property transactions. People in medieval Europe used a payment known as “earnest penny” or “Arles penny” to confirm deals. This small amount of money sealed the agreement between parties.
The term comes from the Latin phrase Argentum Dei, meaning “God’s silver.” At that time, the payment served as a promise to fulfill a deal.
In the 19th and 20th centuries, this practice became more common in real estate. Today, real estate laws and economic systems include this good faith deposit as a standard part of buying and selling property.
| Period | Use |
|---|---|
| Middle Ages | Used as “earnest penny” in land agreements |
| 1800s | Gained popularity in trade and property deals |
| 20th Century | Became part of formal real estate processes |
| Present Day | Common in nearly all home buying transactions |
Types
There are several forms of earnest money based on the nature of the transaction:
Standard Earnest Money Deposit
This is the most common type. Buyers deposit a small percentage of the offer price. This amount shows the buyer is acting in good faith.
Example: A buyer offers $300,000 for a home and provides a $6,000 deposit.
Escalated Earnest Money
In a competitive market, buyers may offer a larger deposit to stand out. This method helps show a strong interest in the property.
Example: A buyer offers $12,000 instead of $6,000 in a competitive housing market.
Non-Refundable Earnest Money
This type of deposit becomes non-refundable after certain conditions are met. It provides the seller with more assurance that the buyer will not back out without a valid reason.
Example: A buyer agrees that after the inspection period, the deposit becomes non-refundable.
How Does Earnest Money Work?
Here is a step-by-step explanation of how this money process works:
- The buyer submits an offer. The offer includes the amount of the earnest money deposit.
- The seller accepts the offer. The buyer deposits the money into an escrow account.
- The contingency period begins. The buyer schedules inspections and applies for financing.
- Both parties meet the terms. If there are no major problems, the deal moves forward.
- The sale closes. The buyer’s earnest money goes toward their final payment or closing costs.
- The deal fails. If the buyer backs out for a valid reason, they may receive a refund. If not, the seller may keep the money.
This process helps ensure both parties act in good faith during the transaction.
Pros and Cons
Here is a comparison of the advantages and disadvantages of using this money:
| Pros | Cons |
|---|---|
| Builds trust between buyer and seller | Buyer may lose money if conditions are not met |
| Helps the buyer stand out in competitive markets | Ties up funds during the escrow period |
| Applied to closing costs or down payment | May lead to legal disputes if contract terms vary |
| Reduces chances of last-minute cancellations | Refund terms may depend on how the contract reads |
Uses of Earnest Money
Earnest money is useful in various types of real estate transactions.
Residential Real Estate
Most homebuyers use this money when buying houses. It shows the seller that the buyer is serious and helps the seller feel more secure about removing the listing from the market.
Commercial Real Estate
In business property deals, the deposit amount is often higher. Sellers want to make sure buyers are committed because these transactions involve more time and money.
Land Purchases
This kind of deposit also plays a role in buying undeveloped land. Buyers often need time to research zoning rules and future development plans. A deposit helps lock in the agreement during that time.
New Construction
Builders may require earnest money before they start building. This helps them confirm that the buyer will not cancel once construction starts.
Resources
- Business Insider. What Is Earnest Money?
- Redfin. Earnest Money Explained
- Zillow. Earnest Money Explained: What Is Earnest Money?
- Bankrate. What Is Earnest Money?
- Investopedia. Earnest Money: Definition and How It Works in Real Estate
