Earnest Money Basics

Home buyers writing a check with an agent holding a key.
••• Philippe TURPIN / Getty Images

Individual state laws and real estate regulations govern the use of earnest money in real estate transactions. All involved in a real estate transaction should be familiar with their state's rules regarding the handling of earnest money, particularly in the failed transaction with a dispute.

In a thesaurus, a synonym for earnest is sincere. When purchasing real property, the buyer offers a sum of deposited money to be held to indicate their sincerity and intent to go through with the purchase process. The amount offered usually correlates somewhat with the purchase price of the real property.

However, this can vary by locality and custom. The amount of earnest money is also normally a negotiable item. The seller does not have to accept the initial amount offered by the prospective buyer. Sellers can require an increase in earnest money deposited for various reasons:

  • Buyer has requested extended period to closing
  • Buyer is offering zero or very low down payment
  • Seller has increased interest or other offers on the property
  • Buyer just offered too little money in the first place
  • Seller is concerned about the buyer's ability to get a mortgage

In some cases, sellers may set a minimum earnest money amount in the listing advertisement. New home builders may also have certain minimum up-front deposit requirements. Most states have very strict rules regarding the handling of and accounting for earnest money deposits.

The money is usually held in an escrow company account, title company account, buyers' broker trust account, or sellers' broker trust account. It is always the buyer's money in a transaction that goes through to closing. On the settlement statement, it is used to offset the buyers' costs in the transaction.

The disposition of earnest money in a dispute and a failed transaction is also spelled out in state law and real estate regulations. In many real estate contracts, the buyer and seller agree to mediate before going to court and taking further legal action. Mediation usually results in an agreement by the parties as to how to distribute earnest money in the failed deal. In many cases just avoiding the cost of mediation will result in an agreement between the parties. In all cases, real estate agents and brokers should place the highest priority on the handling of client funds.

Investors and Earnest Money

Real estate investment involves a number of strategies, and they each have unique characteristics. Some are better if the investor can keep their earnest money deposit to a minimum. Of course, this has a lot to do with the game plan the seller has in place.

When it comes to wholesale, it's a goal to invest as little as possible into the deal. The wholesaler who uses an assignment contract will need to put up some earnest money but will want to keep it low.  The good news is that you're generally working with a highly motivated seller.  They may accept very low earnest money deposits because they haven't been able to sell and want out of the property.

Sure, you can cut a deal on the other end with your buyer to cover your earnest money, but that will only happen if both deals end up closing.  I have heard of wholesalers putting as little as $100 into an earnest money deposit to lock up a property.

The Competitive Situation

In hot real estate markets, buyers may find themselves competing for a property.  Ignoring arguments for or against getting into this situation, if you are and you want the property, earnest money can help.  If you're sure you can perform, get your mortgage and close on the deal, then earnest money is simply a front-end deposit on your down payment and closing costs.

Should you end up in a bidding situation, you really want the home, and you know that you can get the mortgage and close on the deal, then up your earnest money. The seller may be comparing several offers, and there may even be one higher than yours.  However, if you are offering significantly more earnest money, you may get the home!