What Is Earnest Money?
Earnest money, also known as a good faith deposit, is compensation paid at the time a contract is signed. The deposit serves one primary purpose — it shows that the buyer is serious about following through on the contract. Usually, earnest money comes up in real estate transactions, although it could potentially be used in other types of purchase agreements as well. In real estate contracts, it is not the same thing as a down payment, but it is often included as part of the down payment.
In a classic example of the way in which earnest money is used, Party A agrees to buy a house from Party B. The two parties work out the purchase price, and they agree on a contract and sign it together. At the signing, Party A provides a payment of earnest money, which is held by a broker. Once all of the financing and other issues have been dealt with, the earnest money is bundled into the down payment, and Party A takes possession of the house.
From a buyer's point of view, earnest money along with a contract indicates that he or she really does intend to buy the house. Once a contract has been signed, the seller isn't supposed to sell the house to someone else, but the seller might back out if a better deal comes up, even with the risk of potential penalties. When earnest money is involved, backing out becomes harder. For sellers, earnest money is a form of insurance, because most people are unwilling to walk away from their payment.
The value of earnest money associated with a purchase agreement varies. In some communities, people exchange a dollar, or a similarly low unit of currency, as a symbolic act. In other instances, people may put up three percent of the value of the contract. In all cases, the terms surrounding the earnest money are spelled out in the contract — not just the amount of money that will be paid, but what will happen to that money if it is paid, but the deal subsequently falls through. Buyers, for example, might want a refund clause in the event that they cannot get financing, while sellers may desire a forfeit clause so that if buyers walk away for a petty reason, the seller gets to hold on to that earnest money as compensation for his or her time.
Earnest money is usually handled by a real estate agent or broker. It's generally unwise to issue it directly to the seller or to an unreliable third party. Real estate agents are usually happy to handle earnest money payments. Buyers and sellers should be aware that money can potentially sit in escrow for a long time if the deal falls apart and the terms of the contract are unclear, and it may take a trip to court to release the earnest money.
In some cultures, earnest money is known as lucky money. By tradition, the seller gives it back to the buyer when the down payment is provided. The return of the funds is supposed to provide good luck in future endeavors, and to foster good will between the buyer and seller.
Written by S.E. Smith
