Tuesday, May 21, 2013

What Is Earnest Money?

Residential real estate has a language all its own. Escrow, title, trust deed, contingency and so on are clearly English, but to many people who want to buy or sell a home--particularly first time buyers--these terms might as well be Sanskrit. Moreover, everyone involved in the transaction from broker to lender to title officer tosses these words around like peanut vendors at the ballpark. 

Any of these people would be pleased to define the terms, but all too often, the lay person is uncomfortable asking. And once defined, the term has no meaningful context. The Rookies Guide will try to define and explain these terms. This post is about earnest money.

Earnest money is an amount of money a buyer attaches to her sales offer, usually by check. How much? It depends on the market customs. In Oregon, I used one percent of the purchase price as a guide (in Nevada and California, it was a bit higher). An offer on a $300,000 home would therefore have an earnest money check attached for $3,000.

If I represented the seller, I would try to get a higher amount. If the buyer was my client, I'd push for a lower amount, unless there were competing offers. Earnest money is supposed to show how "earnest" a buyer is, and in a competitive environment, offers with higher earnest money checks attached get more serious consideration.

On the other hand, many first-time buyers don't have a lot of spare cash laying around, and coming up with $500 or $1,000 on an entry-level home, especially with closing costs and home inspections, is a stretch. Once again, local markets will dictate the amount.

What happens to your earnest money if the transaction goes through? It applies against the total amount due at closing in some way. Let's say your offer of $250,000 was accepted, and your earnest money check was for $2,000. You've qualified for an FHA loan of $241,250 with $8,750 down. Other closing costs will run $4,800.That means you'll owe $13,550. The earnest money can be credited against this, meaning you'll have to tender a cashier's check for $11,550. You could also get a slightly lower mortgage, which I wouldn't advise. There are also other scenarios for earnest money application, but you get the drift.

What happens to the earnest money if the transaction doesn't go through? This area is where things get complicated. That sales agreement you signed when making the offer is, in reality, more of a description of what happens to the earnest money more than it is a purchase offer. In California, my attorney referred to MLS (Multiple Listing Service) Residential Real Estate Agreements as "deposit receipts."

A buyer who meets his or her obligations will get back the earnest money if the deal falls through. Deals fall through for as many reasons as there are people, but usually it's because of a repair issue or failure for buyer and seller to agree on issues that transpire, such as closing date, possession, etc. Sometimes, the buyer's loan doesn't get approved. These are all contingencies in the agreement.

But buyers need to know their earnest money is at risk. If the Agreement says the buyer will obtain financing and the buyer neglects to do so within the described time frame, the buyer could forfeit his earnest money. The same is true if the buyer gets cold feet and backs out at the last minute.

Most MLS-form sales agreements go to a great deal of trouble spelling out who gets the earnest money in the case of a dispute and generally calls for mediation or arbitration. It's important for buyers (and sellers) to understand this element.

Generations of MLS lawyers have put thousands of hours into these provisions. These attorneys represent the local Realtor associations, not the buyers and sellers. Parties to a sales agreement need to understand these provisions.

What if a seller backs out? Usually, the buyer gets her earnest money back. Can earnest money be non-refundable? Yes, but it usually takes a special addendum to the agreement, signed by both parties, for this to occur.

To sum up, earnest money is intended to demonstrate a buyer's seriousness. Most MLS Sales Agreements are more about the earnest money disposition than they are buying the house. Earnest money is at risk. This blog in no way is meant to offer legal advice, and I very much encourage a buyer or seller to get an attorney's advice.