Whether you’re a buyer or seller of real estate, you may find yourself wondering, “What is an earnest money deposit?”, and why does it matter to me? Even if you haven’t run across the term yet, you likely will once you are making or receiving an offer. Norms and laws around earnest money deposits can vary significantly in different real estate markets. My information is based on my experience as a real estate agent in San Diego, California, however many of the details shared here will still be useful to buyers and sellers outside California. Join me as we dive into the ins and outs of the earnest money deposit and its vital importance to buyers and sellers.
Earnest Money Deposit – Definition and Synonyms
You may hear of earnest money deposit being referred to as good faith deposit, front money, initial deposit, security deposit, or simply, earnest money. It is also sometimes abbreviated as EMD. In its simplest form, I would define the earnest money deposit as funds paid by a buyer to a seller confirming the buyer’s good faith efforts to purchase a home. The rules and laws surrounding how the deposit is handled are usually laid out very clearly in the purchase agreement / contract.
Why is The Earnest Money Needed?
Although most contracts are daunting enough to deter non-serious buyers, the earnest money deposit requirement helps ensure that a buyer is sincerely interested in pursuing a particular home. It’s the real estate equivalent of “put your money where your mouth is.” If a buyer isn’t willing to provide an earnest money deposit, chances are they are not serious about buying the home or property. From a buyer’s perspective, pledging earnest money generally increases the seller’s faith in your offer. Offers without a reasonable earnest money deposit are rarely accepted.
Earnest Money Deposit vs Down Payment
Many people confuse the earnest money deposit with the down payment (when a loan is involved in the purchase). This confusion is with good reason – assuming the deal progresses as planned in the contract, the earnest money deposit is typically applied toward the buyer’s down payment and closing costs.
What is a “Typical” or “Normal” Earnest Money Deposit Amount?
The typical amount is definitely something that can vary significantly in different markets. Here in San Diego, 1-3% of the purchase price is common. Amounts exceeding 3% are more rare here in our market because usually the maximum a seller could potentially retain in the case of the buyer defaulting on the purchase is three percent. This limit is based on both parties agreeing to what is referred to as the liquidated damages clause – it is a part of the Residential Purchase Agreement used in most residential real estate purchases here in California).
The earnest money deposit is sometimes written as a percentage and sometimes as an absolute dollar amount. As an example, on a $1,000,000 home purchase the earnest money might interchangeably be written as 2% or $20,000.
Is more earnest money deposit better? How much to deposit as a buyer (and how much to expect as a seller) is dependent on several factors including the buyer/seller preferences and risk tolerance, and how competitive the market is. In more competitive markets, the earnest money deposit is likely to be higher. All other things being equal, a seller will likely view an offer with a higher earnest money deposit more favorably than a competing, similar offer with a low deposit. Coming in with a low earnest money figure can also increase the chances of a counter-offer from a seller (something most buyers should want to minimize the likelihood of). Even with a single offer, a robust earnest money deposit usually reflects favorably on the buyer.
When is Earnest Money Deposited and Where Does it Go?
In our market, the earnest money deposit is due with the escrow company within 3 days after offer acceptance. Although technically the broker could hold the earnest money deposit, most brokerages try to avoid handling client funds. As a result, buyers here deposit the earnest money with the escrow company handling the transaction. The funds are provided to escrow via wire transfer, cashiers check, or sometimes via personal check.
Wire transfers have started to fall out of favor a bit due to the increase in wire fraud. If you are making a wire transfer for your deposit, please carefully discuss security protocol with your agent and the escrow company handling your transaction. Wire fraud is a serious problem that can catch even seasoned business people off guard.
It’s worth mentioning that if funds are deposited via personal check, the seller should keep in mind they are not funds that can be relied on until payment clears (which can be days after the deposit is made with escrow). In other parts of the country, the earnest money may be handled by the broker, title company or attorneys representing the principals in the sale.
Escrow then holds the earnest money until the purchase closes (when it is applied to the buyer down payment and closing costs), or both parties agree to its release, or until a judge or arbitration award tells escrow to release it to one of the parties.
Is An Earnest Money Deposit Refundable?
Yes and no. For buyers acting in good faith and with contingencies still in place, the earnest money deposit is typically refundable. For example, if the buyer isn’t satisfied with the home’s condition, or their lending falls through, they can typically get their earnest money refunded (again, this assumes the appropriate contingency is still in place). Once the buyer removes all their contingencies, then their earnest money is truly at risk. If a buyer were to change their mind after removing all their contingencies, they have likely forfeited their earnest money to the seller.
Because escrow in our market typically requires mutual agreement or a judges order or arbitration award to release the funds, some complications can come up. Mutual agreement means that both the buyer and seller agree on who the earnest money is going to. In most cases, when a buyer cancels a purchase in good faith and still had their relevant contingency in place, both the seller and buyer agree for escrow to release the funds to the buyer. In that scenario, the buyer may have some nominal expenses deducted from their original earnest money total to cover certain escrow fees. In other cases they get the whole amount refunded.
On rare occasions, a seller may refuse to agree to have escrow release the funds, despite wording to the contrary in the contract. In this scenario, escrow would not have the mutual agreement they require to release the funds. Unless the buyer and seller can agree, the issue would likely go to arbitration or before a judge before getting resolved (most likely in the buyer’s favor when a seller is simply refusing to comply with the contract terms).
In California, there are fewer reasons a seller can cite to cancel the transaction when compared to the buyer. However, in those cases where a seller does cancel, the earnest money deposit would typically be refunded to the buyer. The details of this are spelled out in the Residential Purchase Agreement / contract.
Earnest Money Deposit Refund – How Long Does it Take?
If both parties are acting in good faith and mutually agree to the refund, buyers typically have their earnest money back within a week or so. This can vary, but refunds are handled briskly by most escrow companies, in part because buyers are understandably antsy about getting the funds back in their hands. The escrow company also can’t cancel the escrow fully until those funds are properly disbursed.
Why Buyers Should Care About Their Earnest Money Deposit
For buyers, the amount of earnest money offered can make the difference between securing a dream home or missing out on an opportunity. The earnest money pledged with an offer can be a vital tool (among many others) that a skilled agent can use to strengthen a buyer’s offer. However, the EMD is both a tool and a risk to the buyer. Although buyers losing their earnest money deposit is relatively rare in our market, it can and does happen. If a transaction devolves to the point of a buyer losing their earnest money, how much they committed in funds understandably becomes very vital. The less they put up in earnest money, the less they stand to lose. From a practical perspective, buyers also need to know how much money they’ll need to have readily on-hand to cover the deposit in the short timeframe required in the contract.
Why Sellers Should Care About an Earnest Money Deposit
In competitive markets and in cases where multiple similar offers are being considered, a higher earnest money deposit can sometimes help guide the seller to the most motivated and capable buyer. By accepting an offer, a seller is committing to pull their property off the market for a period of time. This can have significant personal and financial consequences if a deal is to fall through. The earnest money deposit can in some cases be a tool to recoup costs for being off the market when a buyer defaults on their purchase and forfeits their deposit.
Disclaimer and How I Can Help
No matter what market you are in, or where you are in the world, if an earnest money deposit is part of a potential home sale, the process and laws surrounding its handling are likely detailed in the contract for that sale. As a real estate agent in California I cannot give legal or accounting advice, so please do not rely on any of the information in this article without verifying with a knowledgeable professional representing you. While I believe the information to be accurate in our local market, you should consult with your own agent and legal counsel for any real estate matters. Advice, strategy, and risks related to earnest money can be nuanced and will depend on many factors specific to each transaction.
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