What Happens to Earnest Money if a Home Purchase Falls Through?

If your home purchase falls through, what happens to your earnest money depends on two things: why the deal ended, and what you and the seller signed. Most California buyers who cancel under an open contingency get their deposit back. Buyers who walk away after removing contingencies can lose some or all of it. Even then, California law limits how much a seller can keep on an owner-occupied home.

This guide explains how earnest money works under the standard California purchase agreement, the 3% liquidated damages rule, how deposit disputes get resolved, and how to protect your money from offer to closing. It's written by Ali Shariat, a Realtor and licensed loan officer based in Irvine.

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The Short Answer

• You usually get it back if you cancel in writing under a contingency you haven't removed yet (inspection, loan, appraisal or review of seller documents), if late disclosures trigger your statutory right to cancel, or if the seller defaults.
• You can lose it if you back out without a contractual reason, especially after you've removed contingencies in writing.
• The seller's recovery is limited. If both parties initialed the liquidated damages clause and you planned to live in the home (one to four units), a seller's retention of up to 3% of the price is presumed valid. Keeping more than 3% requires the seller to prove it's reasonable.
• Escrow won't pick a side. Funds are usually released only on signed instructions from both parties, or by a court or arbitration decision.

How Earnest Money Works in California

Earnest money (your "initial deposit") shows the seller you're serious. In California it doesn't go to the seller. It goes into escrow, where a neutral escrow holder keeps it until closing. At closing, it's credited toward your down payment and closing costs.

Under the standard California Association of Realtors Residential Purchase Agreement (RPA), the deposit is due within 3 business days after acceptance unless your contract says otherwise. There's no required amount. It's negotiated in the offer. Many buyers size their deposit with the 3% liquidated damages threshold in mind, but in competitive situations some offer more. If you add money later, such as an increased deposit after removing contingencies, it takes a separate signed form to become part of liquidated damages.

For the full picture of how escrow runs from opening to recording, see the escrow process in California.

When You Get Your Deposit Back

You cancel under an open contingency

The RPA's investigation, loan and appraisal contingencies each default to 17 days after acceptance, unless your contract sets different dates. Until you remove a contingency in writing, you can generally cancel based on it in good faith and recover your deposit. Common reasons include:

• Inspections reveal foundation, roof, sewer, electrical or moisture problems that the seller won't address.
• Your loan isn't approved despite a good-faith effort.
• The home appraises below the price and you can't agree on a fix.
• Seller disclosures, HOA documents or the preliminary title report reveal problems you won't accept.

Late disclosures trigger your statutory right

If the seller delivers the Transfer Disclosure Statement, or a material amendment to it, after you've made your offer, Civil Code 1102.3 gives you 3 days after personal delivery, or 5 days after mailed or electronic delivery, to terminate by written notice.

You're using an FHA or VA loan and the appraisal is low

Every FHA purchase contract includes HUD's amendatory clause. It says the buyer isn't obligated to complete the purchase, or to forfeit earnest money, if the appraised value is below the contract price.

The seller can't or won't close

If the seller can't deliver clear title, refuses to close, or otherwise breaches the contract, your deposit should come back to you, and you may have other remedies.

When You Can Lose Your Deposit

• Cold feet after removing contingencies. Changing your mind, finding another house, or a change in plans isn't a contractual reason to cancel once your protections are gone.
• Removing your loan contingency too early. If you remove it before you have real loan approval and the loan then fails, you may have no protection left. As a loan officer, Ali tells buyers not to remove the loan contingency until underwriting has actually signed off on the file.
• Failing to perform. If you don't close after all contingencies are satisfied, you're likely in default.
• Ignoring a Notice to Buyer to Perform. If you miss a deadline, the seller can serve a notice that typically gives you 2 days to act. If you don't, the seller may cancel. What happens to the deposit then depends on the contract and the facts, so get advice quickly.

California's 3% Liquidated Damages Rule

Liquidated damages is the amount the parties agree in advance that the seller can keep if the buyer defaults. California regulates it closely for homes buyers plan to live in.

• Who it covers: under Civil Code 1675, "residential property" means a dwelling of one to four units that the buyer intends to occupy when the contract is made.
• Only money actually paid counts. The clause applies only to the deposit actually paid in cash or by check, not to promised amounts.
• Up to 3% is presumed valid. If the amount retained is 3% of the purchase price or less, the clause is valid unless the buyer proves the amount is unreasonable.
• Over 3% is presumed invalid. The seller must prove the larger amount is reasonable. Courts can consider the circumstances when the contract was made and the price and terms of any resale within six months of the buyer's default.
• Both parties must initial it. Civil Code 1677 requires the clause to be separately signed or initialed by each party and set in bold type of a minimum size. The RPA's liquidated damages paragraph is built to meet this.

The RPA's clause also says that for a dwelling of no more than four units that the buyer intends to occupy, the seller retains no more than 3% of the purchase price, and any excess goes back to the buyer. Here's how that works on a hypothetical $1,000,000 Irvine purchase:

Two caveats. First, if the liquidated damages clause isn't initialed, the seller isn't capped at the deposit, but has to prove actual losses, which can be more or less than the deposit. Second, investors and second-home buyers aren't covered by the 3% presumption in Civil Code 1675. Their clauses are judged under California's general reasonableness rules. Before you initial (or decline to initial) that paragraph, understand the tradeoff.

What Happens in a Deposit Dispute

Escrow is a neutral stakeholder. When a deal falls apart, the escrow holder sends cancellation instructions. The deposit is released, minus any escrow cancellation fees, once both parties sign. If one side refuses, the money generally stays put until:

• The parties reach a written agreement,
• A mediator helps them settle (the RPA requires mediation before most disputes go to arbitration or court), or
• An arbitrator or court decides. Escrow can also file an interpleader action and deposit the funds with the court.

California discourages holding a deposit hostage. Under Civil Code 1057.3, a buyer or seller who fails to sign a release within 30 days of a written demand can owe the amount withheld, plus treble damages of at least $100 and up to $1,000, plus reasonable attorney's fees. There's an important exception: there's no liability when the funds are withheld over a good-faith dispute. If you're owed your deposit, make a written demand, and keep a copy.

How to Protect Your Earnest Money

1. Read the deposit and liquidated damages terms before you sign. Decide whether to initial the clause with your agent's guidance, and consider a real estate attorney for large deposits.
2. Calendar every deadline. Include the deposit due date, each contingency, and the disclosure review period.
3. Do all your due diligence early. Schedule inspections, a sewer camera inspection, insurance quotes and HOA document review in the first week, not the last.
4. Get actual loan approval before removing the loan contingency. A pre-approval isn't the same as an underwriter's conditional approval.
5. Don't change your finances in escrow. New debt, job changes or large undocumented deposits can derail an approval.
6. Cancel in writing, before deadlines. Use the proper form, cite the contingency, and sign escrow's cancellation instructions promptly.

If you're deciding whether a deal is still worth saving, our guide on when to walk away from a home purchase walks through the red flags. Buyers comparing neighborhoods can also start with our Irvine guide.

Key Takeaways

• Your deposit sits in escrow, not with the seller. Under the standard RPA, it's due within 3 business days of acceptance.
• Cancelling in writing under an open contingency, or under Civil Code 1102.3 for late disclosures, generally protects your deposit.
• FHA and VA buyers can walk away on a low appraisal without forfeiting earnest money.
• For owner-occupied homes of one to four units, a seller's retention of up to 3% of the price is presumed valid, and anything over 3% is presumed invalid.
• Escrow releases funds on mutual instructions. Refusing to sign without a good-faith dispute can trigger penalties under Civil Code 1057.3.

FAQs

Writing an offer and want to size your deposit, set your contingency dates and line up a loan approval you can rely on? Ali handles both the purchase as your Realtor and the financing as your loan officer, so nothing falls between the cracks. Contact Ali or call (949) 818-1000.