What Is The Earnest Money Deposit In A Real Estate Transaction?

Karin Carr, Owner
Published on November 14, 2018

First-time homebuyers know that they’ll need a down payment if they hope to get a loan.

What they often don’t know is that they will also need cash to use as what is known as an “earnest money deposit” to submit with the offer to purchase when they find the home they want.

This deposit takes its name from its purpose: It shows the sellers that you are earnest about following through with the transaction to purchase the home – you are, in essence, “putting some skin in the game.”

Although the amount of the deposit isn’t set by law, it varies according to the region and the real estate customs within that region.

Something called “liquidated damages” typically determines how much a savvy listing agent will counsel her clients to demand.

Liquidated Damages

Buried within most pre-printed real estate purchase agreements is a clause known as “Liquidated Damages.” This concept is defined well by Bob Hunt at RealtyTimes:

“A liquidated damages clause sets in advance – at the time of contract formation – what the monetary value of damages shall be in the event of contract breach by one of the parties.”

In other words, should the buyer fail to hold up her end of the bargain, the seller agrees not to sue but to keep whatever amount of money the parties have determined will cover damages.

The amount of liquidated damages is stated as a percentage. In California for instance, that amount in most cases is 3 percent of the sales price of the home.

So, what do liquidated damages have to do with your earnest money deposit? If you default on the purchase of the home, this deposit may be forfeited as liquidated damages.

The liquidated damages clause must be initialed by both parties to be valid and the release of the money must be agreed to as well. Then, there is the issue of trying to prove that you suffered damages.

What Is The Earnest Money Deposit In A Real Estate Transaction?

How Much?

The amount of earnest money you’ll need to deposit will vary by region and also by homeowner dictates. One percent of the purchase price is standard in Northern California but the buyer is typically asked to increase the deposit after the removal of contingencies.

As mentioned earlier, smart listing agents will counsel their clients to ask for an increase that will make the deposit equal to the maximum amount of liquidated damages.

Like many aspects of the residential purchase agreement, the amount of earnest money to deposit is negotiable so – whether you are the buyer or the seller — ensure that you’ve hired a knowledgeable real estate agent that can counsel you wisely.

Earnest money is paid in what ways?

Earnest money is typically paid into a trust or escrow account held by a real estate agency, legal firm, or title company via certified check, personal check, or wire transfer. The monies are maintained in the account until the transaction is completed, at which point they are applied to the buyer’s deposit and closing charges.

It’s crucial to know that, as with any other bank statement, escrow accounts can earn interest. If the earnest monies in the escrow account generate more than $600 in interest, the buyer must file a tax form W-9 with the IRS in order to receive the interest.

How Is Earnest Money Safeguarded?

Prospective buyers should take a few protective measures to safeguard an earnest money deposit. Buyers might first make sure that inspections, financing, and defect contingencies are included. This prevents the deposit from being lost if a significant defect is found or if financing is not guaranteed.

Second, thoroughly read the contract’s terms and adhere to them. In some circumstances, the contract will include a specific deadline for the inspection. The Buyer shall comply with such provisions so as to avoid forfeiture. A competent broker, title business, escrow company, or law firm should be used by the buyer to guarantee the deposit is handled properly.

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