What is earnest money? How much earnest money is required? What happens to the Earnest Money once an offer is accepted and later if the buyer cancels, defaults or closes? These are all very important questions that I answer for clients on an almost daily basis. The short answer is that earnest money is used to show that the buyer is serious, it usually is deposited into a neutral escrow account and applied to the purchase at closing, and it is potentially used for liquidated damages if the buyer defaults.
Earnest Money is typically offered by a buyer in an real estate purchase contract offer. A surprise to most, it is not required in Arizona to create a legally binding contract. A legally binding contract requires consideration and that is supplied by the mutual promises in the written agreement, provided that the buyer’s offer is accepted or that there is a meeting of the minds after back and forth negotiation. This is why a Veteran can buy for Zero down under the opportunities afforded by the Veteran’s Administration. As long as a seller is willing to take the risk, no earnest money is required, not even $1 as may be seen in some advertising gimmicks.
While earnest money may not be required, it is customary and typically desired by a seller in order to reach an agreement. The seller wants earnest money because it shows that the buyer actually has some money and because it could be forfeited to the seller as “liquidated damages” or a pre-agreed penalty, in the event that the buyer defaults on the deal. For this reason, sellers want a lot and buyers may want to get by with as little as possible.
In the Arizona Association of Realtors (AAR) Purchase Contract that is typically used in resale transactions, there is such a liquidated damages clause. The seller has the option to claim the earnest money or sue.
If you are a buyer, you want to know how much to offer and how risky will it be to put down earnest money. If something goes wrong, can the earnest money be recovered? What does default mean?
The amount of earnest money is negotiable and the buyer will want to assess their goals and competition to determine how the amount offered plays into their overall strategy. There is a balance between offer strength and how much they can get away with that varies by seller and situation.
What buyers should know is that the AAR contract provides multiple opportunities for a buyer to cancel without penalty and to receive a full refund of earnest money. If the buyer follows the contract and cancels within its parameters, the earnest money is refunded to the buyer without further consent of seller. Only if the buyer breaches the contract after expiration of due diligence opportunities, and barring some material default by the seller, would the earnest money be at risk. If a dispute arises as to whether there was a default, then the escrow company will typically hold the funds pending mediation or arbitration.
It is also legal in Arizona for earnest money to be deposited in a Broker’s Trust account. I have not seen this in years as brokers don't want the responsibility or liability for dealing with disbursement decisions in cases of cancellation or default. Parties to the transaction are usually better served by electing to have the earnest money deposited into a neutral escrow account.
The above explanations apply to a typical resale transaction. What if the buyer is purchasing a new home? To a great degree, new home purchase contracts are written by the builder/seller and must be read in order to know how earnest money is treated and what scenarios are posed for a refund or forfeiture. The refund opportunities are usually limited and your agent should advise you to read and understand the agreement before you sign it. For example, while the AAR resale contract provides for due diligence contingencies, the new home contract typically does not. While buyers making offers with the AAR resale contract usually request to have their earnest money deposited in a neutral escrow, the new home contract typically requires the buyer to initial a clause stating that the earnest money will be deposited into the builders general account and not a neutral escrow. This, along with the amount of earnest money may or may not be negotiable. It's up to the buyer to access their tolerance for these risks.
Buyers should be prepared to write a check for earnest money when signing an offer to purchase and should know that the earnest money check will be deposited with the named depository and cashed if the offer is accepted. If a buyer is not present when an offer is written it is possible to offer to send a wire. This is negotiable with the seller.