When a buyer and seller agree on a purchase price and terms, the buyer shows the seller a sign of good faith in the form of earnest money. This money, typically 1% to 3% of the sales price or whatever is customary for the local market, is deposited with an escrow agent or title company, a neutral third-party that serves to finalize the transaction for both sides.
Earnest money is designed to protect the seller. It shows the buyer is serious, but if the buyer doesn’t follow through with the contract, the seller could lose valuable marketing time when the transaction doesn’t close. They’ll have to start all over again to market the home. There are also opportunity costs – the seller could have possibly sold the home to a different buyer and perhaps for better terms. For that reason, the seller can keep the earnest money.
This also protects the buyer. The buyer can get out of a sales contract and get their money back if contingencies outlined in the purchase agreement aren’t met. Typical contingencies are that the buyer’s lender agrees to make the loan, the appraisal meets or exceeds the sales price of the home, the home passes inspection or that the buyer sells their current home before closing on the seller’s home.
Earnest money paid upfront in the transaction means the buyer has to come up with less money at closing or the deposit can be used as part or all of the down-payment.