What is Earnest Money?

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Earnest money is a down payment on a significant purchase showing that you are in earnest. Earnest money as a percentage of total sale price can vary considerably, but the sum should be enough for the buyer to feel it's worthwhile to take the property off the market while details such as financing and terms are being negotiated. However, the figure should not be so high that if the deal involves forfeiture of the earnest money, the buyer is financially devastated if the deal falls through.

What is Earnest Money in a Real Estate Deal?

Earnest money is most often used in real estate deals, although it can also be part of transactions such as the purchase or sale of a business, or a major piece of equipment. Real estate deals are extremely complex. They depend on inspections, lengthy contracts and financing that may not be in place at the time of the offer. Once a buyer and seller agree on a price and timeline for working out the details that are still up in the air, it makes sense to solidify their preliminary agreement with an upfront payment which is usually about 2 percent of the sale price.

Why Does a Business Need Earnest Money?

Understandably, a business will need to pay earnest money for certain contractual arrangements such as real estate purchases where an earnest money payment is a term of the contract. If you are looking to buy a commercial property or make another significant business investment that will require earnest money, it is prudent to have this sum comfortably set aside rather than scraping it together at the last minute. Any transaction that requires earnest money will be an important enough financial undertaking that it should be carefully planned. Thus, saving earnest money ahead of time should be part of this planning. Working out the details of a mortgage loan is one of the variables that gets hammered out once the earnest money is paid. Your loan request will be more appealing to a prospective lender if you have proactively saved your earnest money, and if paying it doesn't force you to incur additional debt.

Forfeiting Earnest Money

Just because you pay earnest money to move forward with a real estate deal doesn't necessarily mean you'll lose this money if the deal doesn't go through. Your preliminary contract should specify that if the deal falls through because of an action on the seller's part or because of circumstances beyond both the buyer's and the seller's control, the earnest money is returned to you. For example, your real estate deal will be contingent on the property being compliant with local building codes. If the inspector you hire finds non-compliance with this condition, the seller is legally bound to return your earnest money.

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About the Author

Devra Gartenstein founded her first food business in 1987. In 2013 she transformed her most recent venture, a farmers market concession and catering company, into a worker-owned cooperative. She does one-on-one mentoring and consulting focused on entrepreneurship and practical business skills.