This is part of the Real Estate Contract Fundamentals Series. I’m not giving you legal advice - you’ve got to get that for yourself from a qualified attorney. To get a free copy of the Real Estate Purchase and Sale Agreement upon which this series is based, visit the Monster Purchase And Sale Agreement Download Page.
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If you’ve ever made an offer to purchase real estate, you’ve probably been asked to make an earnest money deposit.
Officially, earnest money is a payment that’s designed to show “good faith”. There’s no legal standard for it. Usually the buyer pays earnest money, but sometimes the seller will do so. Sometimes it’s a small amount - maybe only $10 - and sometimes it’s thousands of dollars.
Generally, it works like this: The buyer puts up a particular amount of money upon making an offer to purchase a property. That money is held by one of the real estate brokers or attorneys/title companies involved in the transaction. When the transaction closes successfully, the money is given to the seller. If the transaction doesn’t close due to default of the seller, the buyer’s money is returned. If the buyer defaults and thus doesn’t close, the seller keeps the earnest money.
Earnest money is not a requirement to have a valid real estate contract. Many real estate brokers will tell you otherwise, but that’s simply a commonly held misconception. However, earnest money is so widely known and expected that it may not be worth your effort to dissuade a seller from requiring earnest money from you.
The real questions about earnest money are:
- How much should you pay?
- Who holds the earnest money?
- What is the criteria for releasing the money?
- What happens to the earnest money in the event that either buyer or seller breaches the contract?
How much earnest money should you pay? I think the answer should be as close to ZERO as possible. Generally speaking, the payment of earnest money does nothing positive for the buyer and should thus be minimized to as little as $5 or $10 if the seller can be convinced of it. The biggest exception to this rule should be in the event that there are multiple parties competing to acquire the property. In that case, a significant earnest money deposit can sometimes be the factor making a seller decide in your favor.
Who holds the earnest money? If the earnest money in question is a small amount, such as under $100, I don’t think it really matters who holds it. But if it’s a larger amount, then you should be sure to either hold the earnest money yourself, or have it held by your broker, attorney or title company. There’s no good reason to relinquish control of your money to a party who isn’t working on your behalf unless it’s absolutely necessary.
What is the criteria for releasing the earnest money? For example: If the buyer inspects the property and finds it unsatisfactory, is the earnest money returned? Or if the agreement is terminated by mutual consent, who receives the money?
What happens if the contract is breached? Of course, the smaller the amount of earnest money you pay, the less this really matters. But a word of caution here:
Many gurus recommend that you pay only $5 or $10 in earnest money and write in a provision that allows you to terminate your contract with the seller and you’ll only lose your earnest money and nothing else.
I don’t disagree with the fundamental idea behind this, but be aware of this: There probably isn’t a judge anywhere in the USA who will allow you to get out of a real estate transaction with damages of only $5 if your decision to terminate the transaction doesn’t have a legitimate basis. So don’t plan to use a real estate contract with a tiny earnest money deposit as a proxy purchase option, because that strategy just won’t pass muster if it goes to court.
I’d love to hear about your experiences and strategies with earnest money! Tell us all about it in the comments area below, and thanks for visiting FreeRealEstateTraining.com!
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7 Comments So Far»
Many gurus mistakenly believe that the “earnest money deposit” is “an exchange of consideration to make the contract binding”. This is simply wrong.
For a contract to be binding, there must be an “equitable exchange of consideration” or the *promise* of an equitable exchange of consideration.
For example, the *promise* to deliver a certain sum of money on a particular date and the *promise* to deliver clear marketable title on that same date creates a binding contract. There is an *equitable* exchange of consideration. The consideration to be delivered by the buyer is equitable to the consideration to be delivered by the seller.
The earnest money deposit is not consideration, because both parties have a claim on that money until the conclusion of the contract. Also, the size of the deposit makes no difference in whether the contract is binding. The earnest money deposit is an invention of the real estate brokerage industry to reduce frivolous offers and to compensate the seller for taking the property off the market in the event the contract fails.
As Bryan indicated, unless you are in a very hot market with multiple offers competing for the same property, there is no need for a large cash deposit. In fact, you can use a promissory note (at zero percent interest) as your earnest money deposit, to be redeemed for good funds upon satisfaction or removal of all contingencies. There is no need to have your cash at risk in a 3rd party trust account until you are certain that you will close the contract. Also be sure that any accrued interest on your deposit is applied to your purchase price at closing or refunded to your upon voiding the contract (exercising your escape contingency).
Some brokers will try to insist on a minimum deposit. Ignore their protestations and use a deposit that you believe will demonstrate your good faith and earnest to close on the contract, and that it will adequately compensate the seller for taking the property off the market in the event that you default. Be sure your contract specifies that deposit is “full liquidated damages” and you are not liable for specific performance.
A valid point - but don’t forget that a “full liquidated damages” clause (while being a good idea) will not be sufficient as meeting a reasonable standard if the earnest money deposit is very small and the contract goes before a judge for litigation. — Bryan Ellis
Also remember that an offer can be withdrawn at any time without penalty or forfeiture before acceptance by the other party. Many brokers do not understand this basic fact of contract law. If you submit multiple offers on multiple properties and one is accepted, you can immediately withdraw the other offers and immediately receive your earnest money deposit on those withdrawn offers. (You should be using a promissory note on all your offers anyway.)
Bryan wrote: There’s no legal standard for it. Usually the buyer pays earnest money, but sometimes the seller will do so.
Why would the SELLER pay an earnest money deposit?
The buyer may demand it. Could be that the seller has a reputation for reneging on contracts. — Bryan Ellis
The seller usually is obligated with a “specific performance” clause on the contract to deliver clear marketable title. The buyer and seller may agree to allow the seller to make an earnest money deposit to be forfeited in the event the seller cannot deliver clear marketable title. You will likely see this situation in a sandwich lease-option deal where the end user has an option to buy from the middleman, but that option is contingent upon the middleman getting clear marketable title from the original seller.
Another situation arises when the buyer intends to make repairs to the property before closing (yes it happens all the time in buy/sell contracts and option contracts). The buyer may require the seller to deposit earnest money (or a promissory note) in the amount of the repairs. In case the seller cannot deliver clear marketable title at closing, the deposit is delivered to the buyer as compensation for the repairs. Repairs made before closing are usually in anticipation of flipping the contract to a retail buyer.
Hi Bryan,
Can you put a clause in your contract that the earnest money will be escrowed in a title company AFTER the property is inspected? Meaning, if the inspection fails the earnest money will not be escrowed and the deal is off. Just an idea, what do you think?
Thanks
Sam
Sam - by all means, that’s a totally reasonable thing to do! — Bryan Ellis | Free Real Estate Training
Hey Brian,
Re: a $5.00 or $10.00 earnest money amount not standing up in court, this is clearly an opinion. What is your data? Are you familiar with a contract on a home that used a small earnest money deposit, placed with either an option agreement or purchase agreement, that went to court? And the seller won? If so, how much was the judgtment? And did the seller ever collect? Absent fraud or mis-representation by the buyer, I don’t think a judge would find in favor of the plaintiff.
Additionally, earnest money on residential real estate usually ranges $500 - %2,000. on average-priced home sales anyway. Almost nobody will take someone to court for that amount of money. Conciliation court would likely be the court that would be used, because hiring an attorney would cost more than the possible judgment the seller would achieve. Plus, collecting on a judgment from someone who doesn’t want to pay can take months. Plus, someone who has just lost a sale of their home would likely concentrate their efforts on getting the home sold, not suing someone. Sure, there are exceptions. Some stupid sellers who are just plain angry and spiteful might sue for spite, but the odds are with the buyer that this won’t happen.
Now that i’ve invested ten minutes in completely refuting this post, :-), I gotta ask — why did you invest time in writing this post with so few buyers ever being faced with court litigation for an “inadequate earnest money deposit” of $500 - 2,000.? You’ve done better in the past. Odds are, your next post will return to their usually insightful character…
Thanks, I think. Note that I never stated that there is case law for my opinion that a $5 earnest money deposit will probably be rejected by a judge. This issue would be different for each state, and possibly even in separate jurisdictions within a state. Nor is it my opinion that it would be reasonable for a judge to make such a ruling. But I absolutely stand by my basic premise: A judge has the option to determine that such a one-sided clause is unenforceable, potentially making the buyer liable for greater damages. Will it happen every time? Certainly not. Is it distinctly possible? Without a doubt. — Bryan Ellis
I suspect every jurisdiction is different but where I come from, if an RE agent is writting the offer, the RE agent tells you what the earnest amt should be (usually $500 for all but HUD offers, they are $1,000) and the RE broker must cash the earnest deposit after the inspection period. I have not not tried a promissory note but have tried having it go to escrow without success. Seems if you want to get your offer past the bottom of the trash can, you play by agent/broker’s rules.
B, you mention (above) that when the transaction closes the EMD is given to the Seller….that MUST be a typo…right? In fact, when the transaction closes the EMD is credited to the BUYER at settlement towards the purchase price or closing costs etc…wherever needed. Are you mixing up “Option fee” as in a “free look period” and EMD? That had to be a typo.
Wasn’t really a typo, but was somewhere south of perfectly articulate. Generally earnest money is held in escrow until closing, at which time it’s indirectly given to the seller by being added to the “pot of money” that’s available for settlement. — Bryan Ellis
Escrowed EMD’s and option fees are incredibly simple to understand but I see daily misconceptions and misunderstandings… even by fellow investors and Realtors. (A BIC in a Coldwell Banker office near Charlotte, NC was just shot in his office over a 1000.00 EMD misunderstanding a week ago…still in a coma…tragic)
Its worth noting the difference between the meaning of “Default” and and “contingency” . Depending on what instrument (contract + addendums) is being used, the knowledge experience and skill of the person writing the offer, and what contingencies are contained therein, a Buyer can easily protect themselves and their EMD no matter what the dollar amount without risking default and forefeiture of their EMD. Properly structuring a transaction weighted in your own favor to protect your own best interests is most definitely a “knowledge is power” situation.
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