What is the point of "earnest money"?

Question

My wife and I are in the process of buying a house. We recently found a place we liked and had our real estate agent make an offer. The offer contract he drew up said that we put a certain amount of money in escrow as "earnest money," which makes sense theoretically as a good-faith deposit.

Except that when I look at the very boilerplate-looking standard contract that he drew up and the seller accepted, it makes it clear in several different places that we can back out, more or less at any time and for any reason or no reason at all, and unconditionally get 100% of the earnest money back:

If Buyer determines, in Buyer's sole discretion, that the results of the Due Diligence are unacceptable, Buyer may either: (i) no later than the Due Diligence Deadline referenced in Section 24(b), cancel the [contract] by providing written notice to Seller, whereupon the Earnest Money Deposit shall be released to Buyer without the requirement of further written authorization from Seller.

What is the point of earnest money if it does nothing to incentivize the buyer's good behavior?

Answer 1

it makes it clear in several different places that we can back out, more or less at any time and for any reason or no reason at all, and unconditionally get 100% of the earnest money back.

In my experience there are specific exit points that are typical:

• financing
• home inspection
• being able to sell the current house

These all have deadlines and definitions.

If the appraisal comes in too low, the lender won't approve the loan at terms the buyer can afford. But the buyer has to do certain things by the deadline. Failing to submit the documents in a timely manner will invalidate this exit point.

Home inspection. The buyer has to schedule it. The seller has to cooperate by making the house available. Then once the report is received the two sides have to come to an agreement. If one can't be reached the buyer can walk away.

Some buyers can't afford to own two houses at the same time. They need to sell the first to be able to buy the new one.

Just walking away from the deal generally won't save the deposit.

Answer 2

Earnest money shows that you're making an offer "in earnest": you're making a commitment to the offer.

Yes, you can back out with no penalty, but you're unlikely to make another offer concurrently, because you have a significant chunk of money tied up in this offer. Sure, some people might take the $50,000 that they have planned for a down payment, and write five $10,000 checks to have concurrent offers, but the assumption is that most people won't do this.

From the perspective of the seller, this gives a good feeling that they can commit to you. Versus someone that might make a dozen offers without earnest money, and exercise their ability to back out after weeks or months and leave the seller back at step 1.

Answer 3

You mentioned that you can back out of the offer at any time, but in the comments you quoted the standard inspection contingency which is generally time limited. In many cases, especially in hot markets, buyer contingencies will be waived.

But it is true that a refundable deposit is not a guarantee for the completion of the deal - that's why it's called a "deposit". Giving non-contingent offers (i.e.: non-refundable deposit) would significantly improve your chances of getting your offer accepted by the sellers. However, even with contingent offers, your ability to put a relatively large amount of money (for a real estate purchase - I'm assuming much more than what you'd be willing to lose) shows at least some level of intent and commitment. People don't usually go under contract for multiple properties with contingencies precisely because they may not be able to give out large amounts of money as deposits for all of these transactions.

You didn't mention what country you're in, but in the US for example the deposit in real estate transactions is usually around 3%. In some cases that may end up being the whole downpayment, especially for entry level/lower priced properties.

Answer 4

If you have ever tried to sell something online through an unstructured system, the number of people offering scams, who don't actually have any money, or who ghost you part way through a deal is huge.

Earnest money guards against all 3 of those.

A scam where I have to put down a few thousand dollars is not one I can do in parallel with 10,000 people at once risk-free. And a lot of scams are of this kind nowadays. Escrow will stop any mass scamming cold (so long as you can verify the escrow agency).

If the buyer ghosts the seller, it means they aren't providing written notice that the deal is off. They are just stopping communication. So the seller keeps the escrow.

If the buyer has no money, they can't put anything in escrow.

The escrow is an easy, concrete step that indicates that you are at least somewhat serious about this. You aren't just window shopping, or a bot, or whatever.

There are also psychological components to it. Even if the deposit is fully refundable, the refund requires an action. In addition, when the buyer puts money in escrow, they are going to do due diligence themselves (with their own lawyer, the escrow agency, etc) which raises the cost of the deal on the buyer's side modestly. Backing out now has sunk costs, even if you get the escrow money back.

Answer 5

Good faith money disincentivizes you from backing out for no reason. You can still back out for good reason.

Say you are selling your house. A buyer offers you 300k, and you take it. Buying a house is not like buying a bicycle, there is a lot of paperwork that goes into it. That takes time. From the buyer's perspective, they don't want to do a bunch of paperwork and inspections only to have the seller announce that he changed his mind and won't sell anymore. Therefore, when offers are converted into a contract where the seller agrees to not entertain offers from other buyers for some time (say 30 days) while the initial buyer is going through all the motions.

This creates a problem from the seller's perspective. What if you get a string of buyers that make a bid, enter the contract, and then keep saying on day 29 that they changed their mind and don't want to buy it anymore. You can't force them to buy it. As a matter of fact, proof of funds is not required to make an offer, so for all you know the guy "offering 300k" has 3 dollars to his name and couldn't get a loan to save his life. You could end up being unavailable to bids 97% of the time, which would really slow down your attempts at selling.

Therefore we have the contract to sell, but also we want only serious buyers to get to this stage. This is effected by taking a deposit from the buyer. The terms of the contract will say that if the buyer just "changes their mind", they have to give up the good faith money. The point is that if you're entering the contract, you should have already made up your mind about buying the house.

But on the other hand, you only get so close a look at the house while making an offer. You can't just hire an inspector to check every house you view before making an offer. So it's inevitable that you would do a cursory viewing, make an offer based on that, enter a contract, and after spending 3 weeks doing inspections find out that actually there is a serious problem with the house and had you known that, you would have never offered what you did. Or perhaps the purchase becomes impossible due to circumstances beyond your control. This is why contracts provide the buyer with some acceptable grounds to back out of the purchase without forfeiting the money.

In simple terms, it works something like this:

• I want to buy the house for X money
• Okay, I'll sell it to you for X
• Great, it will take me some time to get the X ready. Can you tell the other folks to hold off until then?
• Sure, but only if you really mean to buy it. Give me a deposit of Y so that if you change your mind frivolously I will keep the Y.
• Okay, but if I decide not to buy because I discover some serious problem then you have to return the Y.
• Fine, deal.

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You mention also that your contract says you can "back out for no reason at all". That sounds like you may have misread it, because the seller has little reason to accept such a one sided contract. However, even if that is truly the case, the good faith money would still have some role - it would make it difficult for you to make many concurrent bids on different houses.

Answer 6

Oftentimes earnest money checks are cashed immediately if the seller wishes to accept their offer. Logically, there wouldn't be a reason to bother cashing them if they truly had no value.

As other answers have pointed out, normally you can't get your earnest money back for literally any reason. However, even if you were guaranteed to get your earnest money returned for any reason, there's still a pretty significant psychological difference between:

1. I promise to give you X. Let's discuss.
2. Here is some real money you can hold on to (or at least look at) while we discuss.

One lesser important distinction is it proves you actually have some money and aren't just wasting everyone's time (for fun or as a prank- imagine someone putting an offer on a multi-million dollar house just to say they did).

Perhaps the biggest distinction though is simply making an effort. If you think about signing up for a free trial of a service you are interested in, most people are far more likely to sign up for one where all you need to do is provide an email address, compared to those that require a credit card. Even if the service has a no-questions-asked cancelation policy, where you know if you cancel within, say 30 days, your CC won't be charged, just requiring a valid CC is still a significant deterrent. For those that do sign up by providing their CC info, the probability of them becoming a paying customer is far higher. Similarly, buyers who are willing to let the seller hold on to some of their money show a higher degree of true intention to purchase.