If you're trying to buy something large with a contract that's complicated, you may be asked to put some money up front, just to demonstrate how serious you are about the transaction. This is earnest money – money to show you're earnest.
What is it?
What is earnest money?
Earnest money is a deposit you make when you sign a contract for a significant purchase that will take time to execute. It is then put into an earnest money account, typically a designated escrow account, and later dispersed based on the contract you've signed.
Earnest money is almost exclusively used in real estate transactions. Most other transactions can be executed in a few days and require no such serious financial security.
If you had a much simpler transaction, such as buying a car, you might still put down a little money up front, but it would not require the care and handling that earnest money does. You should be able to completely fund that car very quickly. Real estate transactions can take from weeks to months to complete, depending on whether they're residential or commercial and how many conditions must be met.
Normal amount?
How much earnest money is normal?
It is difficult to answer how much earnest money is normal. It depends on what you're buying and where you're buying it.
Freddie Mac, a government-sponsored enterprise that guarantees home loans, says to expect to put up 1% to 5% in earnest money. However, commercial real estate and small business sales experts are quick to point out that you may need as much as 15% for a hot commodity.
The amount of money you provide as earnest money should balance out the risk the seller of the property is taking by removing their property from the market. If they were likely to get better offers very quickly, you need to be prepared to put up more. If their property has not had a lot of interest, a smaller earnest money deposit may be plenty. Typically, you can haggle a bit on earnest money.
Same as money down?
Earnest money versus down payments
Earnest money and down payments are often confused. Your down payment is the money you bring to closing to show the bank that you also have money in the game. This is applied directly to the sales price, and the bank will provide the rest of the funding, aside from what you need for closing costs and prepaid items.
Earnest money, on the other hand, is a refundable deposit you put down when you sign a contract and remove a property from the market. If you fulfill the contract terms, your entire earnest money check will likely be released. Many people then use that as their down payment. However, since it is possible to lose your earnest money, it's not automatically assumed to be the down payment until you're at the closing table.
If it falls through
What happens to earnest money if the transaction falls through?
If you put up earnest money for a purchase and your transaction goes through flawlessly, then there's no problem -- the money flows into your purchase. If something goes wrong, however, that can create a lot of uncertainty.
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Ultimately, what happens to your money should be spelled out in the contract, but you can generally expect one of three outcomes:
- You get all your money back. If it's the seller who fails to perform -- they don't do what they were supposed to do or are unable to sell the property for other reasons -- you'll usually get all your money back.
- You get some of your money back. In some situations, the fault for the contract failing may be split between the buyer and the seller, in which case you may be responsible for some fees or other penalties, but you should get the rest of your money back.
- The seller gets your money. This is the worst outcome, but if you really mess up, the seller will sometimes get your money. This is why it's really important to have contingency clauses for things like your financing and the appraisal. If contingencies are in place and you can't get a loan or the appraisal isn't high enough to get your loan, you will still get your earnest money back.
Generally, most people will get their earnest money back in some form. It's not a system that's designed to take your hard-earned cash. But it also creates a balanced dynamic between buyer and seller to ensure everyone behaves fairly throughout the transaction.
