Understanding Earnest Money

One of the many questions we need to ask our clients when they are writing an offer to purchase a property is “How much earnest money would you like to submit for this offer?”

At times, the blank stare we receive as an answer says it all: “What the heck is earnest money?”

Here’s what we hope to give you in today’s article:

• What is earnest money?
• How much earnest money should I submit?
• Where does earnest money go?
• What happens to earnest money at closing?
• What happens to earnest money if the transaction doesn’t close?

Let’s get started!

What is Earnest Money?

Suppose you’ve written an offer to purchase a home that just went on the market.  The seller is required to change the status on the MLS to “Contingent”, meaning that they are currently under contract to sell the property to you, and they aren’t allowed to accept another offer to purchase the property unless your transaction is terminated for some reason.  (We’ll cover Secondary Offers sometime in another blog post).  Essentially, the seller is passing on all future opportunities and making a commitment to YOU.  If you just change you mind in a few weeks and decide to walk away, the seller may have missed out on several other opportunities to sell the property to interested buyers.  Of course, this can waste money, and time for the seller.  Earnest money is money that the buyer puts into a trust account as a security measure to discourage the buyer from arbitrarily walking away from the transaction, thereby partially protecting the seller from financial harm at the hands of a capricious buyer.

If the buyer knows that walking away from the deal will cost $10,000, he is much less likely to ditch the current transaction for another property that just arrived on the market that he likes a little more.  Earnest money makes sure that the buyer has some “skin in the game”.

How Much Earnest Money Should I Submit?

The offer to purchase form has a space for the buyer to indicate how much earnest money they promise to submit, should their offer be accepted, along with a promise to deliver it within a certain number of days (the default number is 5).  Earnest money is not a REQUIREMENT per se.  A real estate transaction can occur without it, but that would be at the discretion of the seller.  With that in mind, the amount of earnest money a buyer promises should carefully consider several things:

• Are there competing offers?  Sellers will look at all the terms of any offers they receive.  Offers including higher earnest money amounts may be preferred.
• What is the offer price? Most sellers will expect 1%-2% of the purchase price on the low end, but there are times when 5%-10% is appropriate.
• How strong are the other terms of your offer? If the seller perceives that your finances are not as strong as they would like, or if they have any reason to doubt that you’ll be committed to the transaction, one way to put their mind at ease is to increase the amount of your earnest money.
• How much can you afford to deposit? Although the earnest money will be applied to the transaction at closing (more on this later) it’s important to be sure you have that cash on hand to make the deposit shortly after your offer is accepted.

Where Does Earnest Money Go?

Probably the biggest question buyers have is where does this earnest money go after I’ve deposited it?  Earnest money is held in a non-interest-bearing trust account.  There are rules and regulations about the types of funds which may be kept in these accounts:

Client funds are defined by REEB 18.02(1) via the definition of Chapter 452.13(1)(a), as all down
payments, earnest money deposits or other money related to a conveyance of real estate that is
received by a broker, salesperson or time-share salesperson on behalf of the broker’s, salesperson’s

or time-share salesperson’s principal or any other person. Chapter 452.13(1)(a) specifically states

that client funds does not include promissory notes.
REEB 18.02 defines real estate trust funds to mean any cash, checks, share drafts, drafts or
notes, other than promissory notes, received by a broker or broker’s salespeople or time-share
salespeople on behalf of a principal or any other person including, but not limited to:
(a) Payments on land contracts, mortgage payments and any other receipts pertaining to mortgages;
(b) Tax and insurance payments held in escrow;
(c) Advance fees and finder’s fees, unless non-refundable;
(d) Rental application deposits and rents, but only when received while acting as agent for
another;
(e) Payments received for subsequent repayment to a third party;
(f) Security deposits on rental property, except as provided in s. REEB 18.031(4); and
(g) Initial and additional earnest money down payments and other monies received in connection with offers to purchase, options and exchanges, even if the broker, salesperson or timeshare salesperson receives the down payments or monies when negotiating the sale of real
estate or a business opportunity which the broker, salesperson or time-share salesperson
owns in whole or in part, or when negotiating the purchase of an interest for ownership in
whole or in part by the broker, salesperson or time-share salesperson.

The seller does NOT receive these funds.  The listing agent does NOT receive these funds.  The earnest money you deposit is essentially being held safe by a third party throughout the transactional process.

What Happens to Earnest Money at Closing?

When explaining earnest money, we use the phrase “It’s EARLY  money, not EXTRA money.”  At the time of closing, the earnest money you have deposited will be applied directly to the purchase of the property.  In real estate transactions, the buyer will generally need to provide money at closing for their down payment, lender closing costs, escrow for property taxes, and other smaller charges.  Your earnest money will be applied to these costs.  If the earnest money is less than your overall closing expenses, you’ll need to pay the balance at closing, but if your earnest money is higher than your closing expenses, you’ll be written a check at closing to refund you the balance.

What happens to Earnest Money if the Transaction Doesn’t Close?

This is probably the most important, and complicated question related to earnest money.   The answer is: it depends on WHY the transaction didn’t close.  If you back out of the deal for some contractually valid reason, you are more than likely going to be entitled to a full refund of your earnest money.  Contractually valid reasons would include include most contingencies in the offer, like financing, inspection, or appraisal.  If the transaction falls apart because you didn’t get approved for financing, or there were defects that the seller refused to remediate, or the property appraised too low, you can probably expect to receive your earnest money back.  (Consult our other blog posts about these topics to understand the process of using these contingencies correctly).

When a transaction falls apart, the final piece of paperwork needed is called a Cancellation and Mutual Release form  (CAMR).  When both parties sign this form, the transaction is terminated, and both parties agree to release the other from duties required by the contract.  This form also determines where the earnest money is distributed.

The buyer and seller must both sign a CAMR for it to go into effect.  One may think that a seller would be inclined to be stubborn and refuse to agree to distribute the earnest money to the buyer if a deal falls apart, but that’s almost never the case.  It’s important to understand that without the CAMR, the seller is not entitled to re-list their property.  Refusal to sign the CAMR will not generally be in their best interest.  Furthermore, if the buyer is entitled to a refund of that earnest money, a refusal to sign the CAMR will only delay the inevitable, since the case will then end up in arbitration and the money will eventually be distributed correctly anyway.

If the buyer simply decides to walk away, however, without any contractually valid reason (got cold feet, found another house they liked more, for example), the seller may be entitled to the earnest money.  A buyer may try to negotiate or appeal to the seller for a full or partial refund, but ultimately the decision on how to move forward in those cases will be in the hand of the seller.

In Conclusion

If you’re a buyer, earnest money isn’t something to be nervous or worried about, but you SHOULD be thoughtful about how much you promise in your offer.  It’s never a good idea to over-extend yourself, and you should remember to protect yourself from undue risk.  Sellers rightly expect a buyer to have some skin in the game, so earnest money is a fair way to introduce that to the relationship.  With that in mind, be careful how you proceed with other elements of the transaction (inspections, testing, financing) because the earnest money provides important checks and balances which create consequences for your decisions.

Do you have questions about earnest money?  We’d love to hear from you!