When Buying & Selling a Home - What is Earnest Money?
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When buying or selling a home or any other piece of real estate, it is customary for the buyer to provide some amount of earnest money to be held in escrow until the completion of the transaction. What is earnest money and what is most important to understand from the home buyer and home seller’s perspectives?
Earnest money can be considered a kind of security deposit in the purchase of real estate. When a buyer makes an offer to purchase a property, the offer is traditionally accompanied by earnest money funds or the promise of delivery of these funds within a limited time frame (usually a few days). The amount of earnest money expected varies by state and by market. In the Greater Lafayette, IN residential real estate market, 1% of the purchase price is customary. At higher price points that amount may be a smaller proportion. Again, this is market specific.
Where is Earnest Money Held?
These funds are usually deposited in an account where they are held in trust for the benefit of the buyer. This may be held by the brokerage with the listing contract (the property seller’s agency) or with the title company where title work and the closing (the completion of the transaction) take place. The buyer will be credited this amount at the closing. This credit reduces the amount of funds the buyer will need to bring to the closing.
Earnest Money are “At Risk” Funds
Home buyers should know that earnest money funds are at risk funds. This means that the buyer must perform and abide by the terms of the written purchase contract in order to retain their earnest money. The buyer may walk away from the purchase and be refunded their earnest money if the contract is terminated due to a contingency of the purchase. In the state of Indiana, buyers are protected by several contingencies in the contract to purchase. For example, if the property doesn’t appraise at or above the purchase price, the buyer would be released from the purchase contract and have the earnest money refunded. If the buyer simply changed their mind or tries to “escape” the contract without the benefit of a contingency, the buyer will lose their earnest money and it will be distributed to the seller.
Earnest Money Highlights
From the Home Buyer’s Perspective
- Like a Security Deposit - Think of earnest money like a security deposit held in trust. At the completion of the sale these funds are credited to the buyer.
- Amount - In the Lafayette and West Lafayette real estate market, it is customary for a buyer to provide approximately 1% of the purchase price in earnest money. This amount can be smaller on higher purchase prices. This amount varies by market.
- At Risk Funds - Earnest money is at risk. If one party to the purchase contract is non-performant (in breech), the earnest money will be distributed to the performing party.
- Buyers Keep - Buyers keep the earnest money if they close on (complete) the purchase or if they are released from the contract due to a contingency (e.g. the property doesn’t appraise at or above contract price).
- Buyers Lose - Buyer will lose their earnest money if they simply change their mind about the purchase, try to escape over a small (non Defect) repair or maintenance item or otherwise not perform to the purchase contract.
From the Home Seller’s Perspective
- Demonstrates Buyer Commitment - Earnest money shows that a buyer is serious about the purchase and is willing to put some funds at risk to work through the due diligence phase of the purchase.
- Supports Buyer Performance - Sellers have the assurance that a buyer can’t simply “walk away” without losing the earnest money deposit.
- A Form of Compensation - The seller can consider the earnest money as a form of compensation for the time the property was off the market after an accepted offer if the buyer walks away and is in breach of the purchase contract.
Distribution of Earnest Money - Mutual Release
In the state of Indiana, a mutual release is used to terminate the contract to purchase and identify who shall receive the earnest money. The earnest money is provided to the buyer if both parties perform to the contract. If one party is in breach of the purchase contract the earnest money is distributed to the performant party.
About the Author
- Don Stocks is a real estate broker with the Nexus Realty Group at Coldwell Banker Shook in Lafayette, Indiana. He specializes in representing buyers and sellers of residential real estate in and around Lafayette and West Lafayette, IN (Greater Lafayette). His professional experience includes Fortune 50 Enterprises, high-tech / IT startup ventures and early stage strategic management consulting. He holds an MBA and a BS in Management from Purdue University. He lives in Lafayette, IN with his wife Ronda and his son Adam. When he's not real estate-ing, he enjoys reading non-fiction, hanging out with is family on their sailboat “Andiamo” and sailing on Lake Michigan.