Earnest Money: Definition in Real Estate Transaction
Earnest money, sometimes called “good faith deposit,” is a deposit made by a buyer in a real estate transaction to show the buyer's good faith and commitment to completing the sale. In many states this deposit is typically held in an escrow account by the listing agent (common practice in New York State, specifically WNY) or a third-party escrow company, some states it is held buy buyer’s attorney (common in the state of South Carolina, specifically in the lowcountry areas of Bluffton and Hilton Head Island). The amount of the deposit can vary depending on the purchase price of the property and the terms of the purchase agreement. In many states the typical amount of the deposit is between 1% and 3% of the purchase price, but can be higher or lower depending on the specific circumstances of the sale. This amount can vary greatly from transaction to transaction. Many cash buyers will put up a higher amount to show their financial strength to a seller, especially in a multiple offer situation. Many younger (less time to accumulate cash/savings then older homeowners) or first-time home buyers may have less cash on hand to put a larger amount forward as the their financial resources, cash on hand, may be less and needed to put toward a down payment or other costs associated with a move/relocation. This doesn’t indicate a “worse buyer,” but to some sellers the higher amount may indicate the buyer is less apt to back out of the agreement.
The purpose of the earnest money deposit is to protect both the buyer and the seller in the real estate transaction. For the buyer, it acts as a demonstration of the buyer's commitment to the sale and ensures that the buyer will not back out of the deal without a valid reason. If the buyer decides to back out of the deal without a valid reason, the seller may be able to keep the earnest money deposit as compensation for the time and effort spent on the sale. On the other hand, if the seller backs out of the deal without a valid reason, the buyer may be entitled to a refund of the deposit.
In many states, the terms of the earnest money deposit and the circumstances under which it may be refunded or forfeited are typically spelled out in the purchase agreement. For example, the purchase agreement may specify that the deposit will be refunded if the sale does not close due to the seller's inability to provide clear title to the property or if the buyer is unable to secure financing. It is important for both the buyer and the seller to fully understand the terms of the purchase agreement and the consequences of the earnest money deposit before entering into a real estate transaction. This is a big difference in the states where I am personally licensed in (New York and South Carolina). Many agreements in NY the earnest money isn’t due until after both attorneys approve of the contract and, if there’s a home inspection, the signing off of the home inspection addendum (Property Inspection Notification Addendum - PINA) by both buyer and seller. In South Carolina, to by a executed/legitimate purchase agreement (contract) there must be an exchange of financial funds (earnest money); therefore, the earnest money is paid upon the execution of the contract. Sometimes this amount may be divided into 2-payments: One at execution and another after the due diligent (home inspection) period. There is another difference between both states as NY home inspection period in a residentional sale is typically no more than 7-days. South Carolina the time frame is typically 14-days.
It is also important to understand, many times this earnest money amount is put toward the buyer’s down payment and is always put toward the final purchase price.
To conclude, earnest money is an important component of real estate transactions and serves to protect both the buyer and the seller. It is a demonstration of the buyer's commitment to the sale and can be used as compensation if either party decides to back out of the deal without a valid reason. It is important for both the buyer and the seller to fully understand the terms of the purchase agreement and the consequences of the earnest money deposit before entering into a real estate transaction. Be sure to always check with your real estate salesperson for your states laws as well as best practices when it comes to earnest money. Your mortgage lender is also an important resource in the application/amount of your earnest money (“good faith deposit”).
