Unraveling the Mystery of Earnest Money

Sometimes prospective home buyers are a little surprised as they step into my car when I ask whether they brought their checkbook.

“Why do I need my checkbook?”

“Because we can’t make an offer without earnest money!” *

What is earnest money?

Earnest money is the consideration paid towards the purchase of real estate demonstrating the seriousness of the offer and represents the buyer’s level of risk in the transaction. In other words, it shows the seller whether the buyer is serious about the purchase or not.

Earnest money is normally given to the agent in the form of a check at the time the offer is written. If the offer is rejected, the check is returned to the buyer. If the offer is accepted and becomes a contract, the earnest money is deposited into an escrow account at the agreed-upon escrow company.

What happens to the earnest money if…

(all responses are based upon the Arizona Association of Realtors Residential Real Estate Purchase Contract)

• The buyer cancels the contract under one of the contingencies, such as the inspection period? Then the full earnest money is returned to the buyer as part of the cancelation.
• The buyer is not able to obtain a loan? As long as the buyer has made a good-faith effort to obtain a loan, then the earnest money is returned to the buyer.
• The buyer is not able to come up with the down payment? In this case, the earnest money would be released to the seller as this is a failure of the buyer to perform and is fully in the control of the buyer.
• The seller fails to perform, such as closing on-time? Then the earnest money is released to the buyer.
• The buyer finds a different house and cancels the contract? The earnest money is released to the seller as “changing one’s mind” is not a contract contingency.

Earnest money is intended to demonstrate the level of risk each party is willing to accept by participating in the real estate purchase agreement. It represents how much the buyer is willing to lose should they need to walk away for reasons other than those contingencies described in the contract. Likewise, earnest money represents the level of liquidated damages a seller is willing to accept if the buyer fails to perform on the agreement.

*Technically speaking, a seller could accept an offer without earnest money, but it would be outrageously foolish for a seller to accept the risk of removing their home from the market without any possibility of liquidated damages in the event of buyer non-performance.