Earnest Money

What is Earnest Money?

Earnest money, also known as a pledge, is a certain amount of money that a buyer pays to a seller to demonstrate his good faith and intention to complete the transaction. The amount is usually 1%-2 % of the sale price or a fixed amount.

Earnest money is also known as a binder or token money. It essentially confirms a contract and after the earnest money is paid, both the parties to the contract are under the obligation to carry forward the verbal agreement.

Often found in real estate deals, earnest money can be used to give a buyer more time to seek financing or find the remaining sum of money to cover the full price of a property. Compared to a simple deposit, earnest money is not exclusively held by the buyer but is also placed in an escrow trust or a trust account held by both sides.

Understanding Earnest Money

For buyers, earnest money serves to prove to sellers that they are serious about a certain transaction. It gives the seller an incentive to continue the transaction and wait until the buyer finds the funds to settle the full amount.

Earnest money is made as an initial prepayment in the sale process. However, if the deal falls through for any reason, the buyer may not be able to return the pledged amount.

It is especially true if the transaction is canceled through no fault of the seller. So, earnest money can be refundable or non-refundable, and the latter is usually the case.

How It Works

Earnest money is not always paid directly to the seller. Creating an escrow account by a third-party broker helps to ensure the proper distribution of money at the end of the transaction.

As soon as the seller accepts the offer, the buyer is required to sign a contract known as a “purchase agreement.” The agreement stipulates the process of transferring the earnest money to the seller and also means that both parties are in a legally binding agreement relevant to a particular subject like a house purchase or sale.

As soon as the contract is signed, the buyer is required to make an earnest money deposit to the escrow account held by the real estate agent. When all the conditions of the purchase and sale are met, the money is paid to the seller as part of the purchase price.

However, if the buyer fails to source funds for the purchase or decides not to proceed with the transaction, he can get his money back, provided it is noted in the contract.

The concept of earnest money is based on the fact that the contract is not the buyer’s obligation to purchase the property. Many things can go wrong between an earnest money deposit (EMD) and the deal’s closure. Home inspections can detect defects that violate the deal; appraisals can be substantially low. In such cases, the buyer may have the right to take his money back or at least recover a part of it.

When a seller accepts a purchase offer, it is contractually obligated to remove the property from the market for a while until measures are taken for unforeseen circumstances, such as inspections and evaluations.

Earnest Money Deposit (EMD)

In many cases, the buyer can expect that the earnest money deposit amount will be at least 1% of the purchase price, although sometimes the rates reach 2%-3%. Below are some of the factors that affect the EMD amount:

• The current state of the real estate market. If homes sell quickly, a seller may require a higher EMD amount.
• The overall property values
• If more than one buyer has placed a bid on a property, the bidder offering the highest amount of earnest money might secure the agreement.

Earnest Money vs. Downpayment

The amount of money paid to a seller upfront when a property is bought is called downpayment. When a buyer pays earnest money, it shows intent to purchase a house, whereas a downpayment is usually paid after a contractual agreement is signed, and the purchase is on its way to being completed.

A downpayment of usually 20% must be produced by the buyer for the lender to approve the loan on the house. The remaining amount is usually financed by a bank. In a nutshell, an earnest money deposit is a promise to the seller of the property, and a downpayment is a promise to the lender.

More Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Cash Consideration
• Definitive Purchase Agreement
• Real Estate Financial Analysis
• Seller Representation Agreement
• See all valuation resources
• See all equities resources