What the Heck is Earnest Money?

And how do I use it?

Your earnest money better be a little more than this

You are buying that investment property. You have your terms figured out, but your broker asks you how much earnest money you want to put in. So, what the heck is earnest money?

Earnest money is the money that you put at risk in an effort to comfort the seller that you as the buyer are being earnest about your offer. It was designed as a way to put some money at risk and try to weed out the tire kickers. As a seller you don’t want your property tied up multiple times only to find that the buyer can’t perform. Earnest money is sometimes called an earnest money deposit or EMD or escrow money. Ernest money is deposited in a third party who is disinterested in the deal. Many times this is a title company but it might be a real estate broker or an attorney. The important part about this is that the party needs to be disinterested. Be sure to avoid depositing money into account related to the seller such as the sellers real estate broker. On the seller’s side you should be skeptical of a buyer asking to deposit earnest money into the buyer’s broker’s agency account. Either way, is a lot easier for them to get their money back even if they haven’t performed.

How is Earnest Money Used?

Earnest money is deposited into the third party’s account. They are not allowed to use that money for anything other than for the transaction. They’re only allowed to release that money once certain conditions are met. Most likely it is because sale closes and the earnest money becomes a credit to the buyer at the end of the transaction. If the buyer put it in $1,000 earnest money deposit and they’re buying a $100,000 house, on closing they’d have a $1,000 credit and have to bring $1,000 less because they already deposited that money.

Earnest money can also be forfeited. A purchase agreement is an agreement to deed ownership of a property to someone else at a certain time (closing). The buyer backs out of the deal The only recourse the seller has is to receive the earnest money deposit as compensation for his lost time on the market. Of course at this point the buyer is going to want to have his earnest money back. Because of this purchase agreements usually have contingencies. For instance, the financing contingency kicks in if the bank refuses to issue a loan. The buyer would get his earnest money back in the deal with be dead. There’s also an inspection contingency typically. And there may be other contingencies such as a diligence contingency.If there are no contingencies, then the seller is entitled to the money.

How can I use interest money to my advantage?

As a seller, you’ll be looking for the highest amount of earnest money deposited as that will tell you that the buyer is willing to risk more and theoretically should be more likely to close a deal. As a buyer you’ll want to know what’s typical in your area. 1% of the sale price is often used. If you can put more at risk then your offer will be more attractive than most others.

What if there’s a dispute?

Sadly, purchase agreements are not always perfect. Sometimes there is a disagreement on a date that something should have been done or whether or not something was received. Any number of other things can cause a dispute. With the dispute the deal will not close. Both parties will want to get that earnest money. Typically there will be some attempt at mediation. Usually the earnest money is a smaller amount than it would cost to pay an attorney to litigate. If the dispute isn’t resolved then that money will languish in the trust account until the court orders it be paid to someone. I’ve heard horror stories of money tied up in accounts for years and no one can use it. If there is a dispute, in the end it’s unlikely that you’ll get all of your earnest money back. At least some of it will be paid in attorney’s fees. Or you’ll decide that it’s not worth the effort but you won’t give it to the other party and it will stay in that trust account.

When you’re depositing earnest money be prepared that you may lose that earnest money despite all of your best efforts. To make the size of your deposit solid enough to draw the eye of the seller but not enough that you can’t recover from losing it.

Dr. Equity