Defined simply by Webster’s as:  money given by a buyer to a seller to bind a contract, `earnest money’ is a key component of the real estate transaction.  The word `earnest’ by itself is defined as follows:  1. a portion of something, given or done in advance as a pledge of the remainder,  1. anything that gives pledge, promise, assurance, or indication of what is to follow.  There is nothing too complex about those definitions.  However, in a real estate contract there are a few other things to consider about earnest money.

In the Arizona Association of REALTORS^® Residential Resale Real Estate Purchase Contract, the blank on line 9 calls for identification of the amount of earnest money being offered by the buyer.  This is where most buyers will offer some amount of money that they feel is appropriate.  How is that decided upon?   How much should it be?  What is it based on?  Is there a standard or typical amount?  Should it be a percentage of the purchase price?  Do you have to offer earnest money at all?  Well, these are all good questions, but there isn’t one simple answer – as in many things related to the real estate transaction: the best answer is “It depends”.

Incidentally, don’t forget to identify on line 9 what is supposed to happen to that money at closing.  For example, it might read:

9. $ 1,000.00  Earnest money  - to be applied to down payment at C.O.E. ,

or whatever is intended to happen, e.g. refunded to buyer, applied to closing costs, or whatever.

Now, let’s look at all of the other provisions in the contract regarding earnest money.  The next time it is mentioned is in the Section 3. Title and Escrow, on lines 116 through 120:

Release of Earnest Money:  In the event of a dispute between Buyer and Seller regarding any Earnest Money deposited with Escrow Company, Buyer and Seller authorize Escrow Company to release Earnest Money pursuant to the terms and conditions of this Contract in its sole and absolute discretion.  Buyer and Seller agree to hold harmless and indemnify Escrow Company against any claim, action or lawsuit of any kind, and from any loss, judgment, or expense, including costs and attorney fees, arising from or relating in any way to the release of Earnest Money.

In Section 6. Due Diligence, we find two more provisions about the return of earnest money.  Under the Subsection called Buyer Disapproval, the following excerpts are found:

If Buyer, in Buyer’s sole discretion, disapproves of items as allowed herein, Buyer shall deliver to Seller notice of the items disapproved and state in the notice that Buyer elects to either:

(1)     immediately cancel this Contract and all Earnest Money shall be released to Buyer,…

and,

… (2)(c) If Seller is unwilling or unable to correct any of the items disapproved, Buyer may cancel this Contract within five (5) days after delivery of Sellers response or after expiration of the time for Seller’s response, whichever occurs first, and all Earnest Money shall be released to Buyer. 

Section 7. Remedies has a provision beginning on line 275:

Breach:  In the event of a breach on Contract, the non-breaching party may cancel this Contract and/or proceed against the breaching party in any claim or remedy that the non-breaching party may have in law or equity, subject to the Alternative Dispute Resolution obligations set forth herein.  In the case of the Seller, because it would be difficult to fix actual damages in the event of a Buyer’s breach, the Earnest Money may be deemed a reasonable estimate of damages and Seller may, at Seller’s option, accept the Earnest Money as Seller’s sole right to damages; and in the event of Buyer’s breach arising from Buyer’s failure to deliver the notice required by Section 2a, or Buyers inability to obtain loan approval due to the waiver of the appraisal contingency pursuant to Section 2c, Seller shall exercise this option and accept the Earnest Money as Seller’s sole right to damages.  An unfulfilled contingency is not a breach of Contract.

A little administrative housekeeping about earnest money is addressed beginning on line 352 of the contract:

Earnest Money:  Earnest Money is in the form of:  ___ Personal Check  or,   Other _________________.  If applicable, Earnest Money has been received by Broker named in Section 8r (the Buyers agent) and upon acceptance of this offer will be deposited with:  ___ Escrow Company  or ___ Broker’s Trust Account

The “other” referred to there allows for literally anything of value that might be offered and accepted.  Though very rarely done and probably ill-advised, it would be possible to use jewelry, a car, six chickens or anything both parties might agree to.  And the choice of Escrow Company or Trust Account usually defaults to an escrow company.  Very few real estate brokers maintain a trust account these days.

And one final contractual provision regarding earnest money appears in Section 8p beginning on line 360: 

Terms of Acceptance:  This offer will become a binding Contract when acceptance is signed by Seller and a signed copy delivered in person, by mail, facsimile or electronically, and received by Broker named in Section 8r by __________________, at __________ a.m./p.m., Mountain Standard Time.  Buyer may withdraw this offer at any time prior to receipt of Seller’s signed acceptance.  If no signed acceptance is received by this date and time, this offer shall be deemed withdrawn and the Buyer’s Earnest Money shall be returned.

Now that we’ve identified all of the contractual language that deals with earnest money, let’s consider the original questions posed.

Is earnest money contractually required?  The answer is, no.  You can have a perfectly valid contract with earnest money.  It may be unlikely that a seller would agree to a contract without earnest money but they might.  The point is, it isn’t contractually or legally required.  If you can get a seller to agree to not having any earnest money, that would be great.

What is the purpose of earnest money?  Well, it should be clear that it is offered to show the good faith of the buyers and to provide for an agreed upon monetary penalty in the event that the buyers do breach specified contract provisions.  Without it, under most normal market circumstances, sellers are unlikely to proceed.

Well, if most sellers are going to want earnest money as part of the contract, how much is it supposed to be?  There really isn’t any standard or magic formula to make this determination with.  The natural tendency may be for buyers to offer as little as possible and still get their offer accepted and for sellers to ask for as much as possible and still get the offer made.  Some people will suggest that the amount be a percentage of the purchase price, e.g., one percent – or two percent – or some other percentage.  Others may say that it should just be rounded dollar amount like $1,000, or $2,000, or $5,000.  There really is no basis for such numbers other than perhaps local custom or simply what the agent is accustomed to recommending.

And of course, the value of the house may be part of the consideration.  Should there be more earnest money when purchasing a $750,000 home as opposed to a $160,000 home?  Maybe – maybe not.

As a sidebar to this discussion - some new home builders will insist on relatively large sums – sometimes five percent of the purchase price.  Also, they almost always have their own contracts and they do not treat this money as earnest money.  They treat it as a nonrefundable deposit – a very different thing.

Will market conditions influence the amount of earnest money?  If a strong sellers’ market exists and there are multiple offers on a property, the amount of earnest money may be the reason one offer is successful and another is not.  Sellers may be able to demand a larger sum.

Keep in mind the rules about how the earnest money is going to be utilized and what events trigger a forfeiture of earnest money.  What purpose does it serve?   Well, certainly one of the things earnest money does is make people pay attention to timelines and deadlines.  If you do not perform on schedule, the earnest money can quickly be at risk or lost.  So, consider whether the amount of punishment due to losing the earnest money is proportional to the nonperformance.  Conversely, from the sellers’ point of view, how much inconvenience, economic loss or damage, or lost opportunity to sell could there be resulting from a Buyers’ breach?  Is the amount of earnest money just compensation for those things?

OK, so there are lots of things to consider that may factor into the decision of how much earnest money should be made part of the contract.  There isn’t just one answer for all circumstances.  However, there is another contractual provision we haven’t looked at yet.  It doesn’t specifically relate to earnest money per se, but it could affect what happens in a dispute.

Section 7d., line 293 of the contract states, in part: 

Exclusions from ADR:  The following matters are excluded from the requirement for Alternative Dispute Resolution hereunder:  (i) any action brought in the Small Claims Division of an Arizona Justice Court (up to $2,500) so long as the matter is not thereafter transferred or removed from the small claims division;  …

So what does this mean?  In Arizona, the dollar limit for small claims court is $2,500.  Small claims court costs are pretty low – starting at $40.  There are no attorneys and you get simple, straightforward enforcement of contractual terms.  If a dispute involves a dollar amount larger than the $2,500 limit, attorney and court costs start to go ballistic – typically $5 - $10,000 or more.  And, the losing party is required to pay the other side’s legal costs too.  And, I haven’t mentioned how long this process can be.  Oh – and one more by-the-way, it may prove difficult to sell a property that is the subject of a legal dispute.  Obviously, there is going to be plenty of stress and distraction as well – maybe time off from work will be necessary.  It is going to be a mess.

Bottom line – why would you ever offer more than $2,500 earnest money?  From the buyers’ perspective, depending on the price of the home, market conditions, knowledge of competing offers, etc. start off with an offer of earnest money of  $500, or $1,000, or $2,000, but never more than $2,500.  If the seller counteroffers for more earnest money than $2,500 then have your agent, have this discussion with the seller with the sellers’ agent present. 

One other related point to make.  It is the buyers’ right to choose the escrow company on line 91 of the contract.  There are occasions where the sellers’ will try to force a buyer to use a certain escrow officer because they are going to enjoy some type of discount on fees.  They simply do not have that right.  Nor does a sellers’ real estate agent have this right.  Some sellers’ agents like to be a little pushy and try to steer the business to their favorite escrow officer – simply because they’ve had good experience with them, or they are just friends, or their location is convenient.  Hopefully those are the reasons – if the real estate agent is benefiting financially in any manner then it would be an illegal act – a violation of HUD’s RESPA rules.

An exception would be if the property is bank owned or in foreclosure, then that seller can choose the escrow company.  Usually, this means they have already paid for all of the title work and the escrow company is legally empowered to handle the transaction.

Remember, it is the escrow company “in its sole and absolute discretion” who is going to be making the decision about whom to release the earnest money to in the event of a dispute.

DISCLAIMER

John P. Hale is owner and Designated Broker of Touchstone Residential Realty, Inc., 2485 West Tom Watson Drive, Tucson, Arizona 85745.  He has been a residential real estate agent in the greater Tucson Metropolitan area since 2000.  In addition to being licensed as a Broker rather than a salesperson, John holds the following designations awarded by the National Association of REALTORS^®:  ABR – Accredited Buyer Representative, ASR – Accredited Seller Representative, CRS – Certified Residential Specialist, and GRI – Graduate Realtor Institute.  And, John is among the very few that have been named, MRE – Master of Real Estate by the Arizona Association of Real Estate.