Earnest money

Earnest moneyEarnest money

Earnest money has been the subject of some confusion, so let’s talk about what it is, and what it is not.

Consideration

Recall from our discussion about contracts that consideration is a necessary component of a valid contract. A lot of people think that contract consideration is the same thing as money. That’s often incorrect. In some contracts — especially real estate contracts — consideration is the simple exchange of promises to do something in the future.

So where does earnest money fit into this scenario? Simply put, when a buyer submits an offer, it usually includes something of value to indicate to the seller that the buyer is earnest about making this offer, and intends to see it through to the final completion of actually buying the property. It looks like the buyer is willing to place something valuable “on the line” in order to get  (i.e. “in exchange for”) the seller to take the property off the market, and that’s where the whole earnest-money-equals-consideration confusion starts.

Let’s take a closer look at what’s really happening, and you’ll see where that’s wrong.

Really, the contract is based on a buyer’s promise to buy in exchange for the seller’s promise to sell at some future date. That is the consideration in that contract. The “things of value” are their promises; no money needs change hands.

In order to demonstrate to the seller that the buyer really intends to buy the property, and that the buyer’s promise means something, the buyer usually sends along something of value to show earnestness. That’s the earnest money. The vast majority of time, this is a personal check, but it could be anything from cash, to a diamond ring, to a car. It just needs to be something that has sufficient value that it would cause the buyer significant pain to lose it.


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Earnest money promissory notes

In an interesting twist that isn’t used very often, sometimes the buyer will use a promissory note — an IOU — as the earnest money when submitting an offer. I’ve only been involved in one transaction that involved this kind of earnest money, and, as you can imagine, the seller was not too keen on it.

What’s happening is that the buyer, to prove he’ll live up to the promises made in the contract, is making another promise to pay some amount of money in the future. It’s an interesting tactic that can be useful in the right time and place.

When would it be used? Most often when the cash that would normally be used as earnest money is tied up somehow. Perhaps it’s in a certificate of deposit that has not yet matured, or another asset that needs to be sold first. The key is to have a certain date that is relatively soon when the promissory note earnest money will be converted to cash. Until that date, the IOU — the earnest money promissory note — is an asset with value.

Market factors

Buyers should always be aware of the relative strength of the market. Sellers use earnest money as a way of weeding out offers, and when the market conditions favor sellers, they can — and will — demand more in earnest money to see which buyers might be more serious.

How much earnest money you need will vary depending on whether we’re in a buyers’ market (you’ll generally need less earnest money) or a sellers’ market, where you’ll probably need more. Strengthen your offer and increase the earnest money to help avoid a bidding war. If the seller is at all concerned that the buyer isn’t serious, the seller will usually ask for a larger earnest money deposit.

What happens to earnest money?

So what happens when the seller accepts the buyer’s offer, and the property goes “under contract”? Does the seller keep the earnest money as a bonus? No, not at all. It simply becomes part (or maybe all) of the buyer’s down payment, and will be credited to the buyer on the closing statements.

If you’re thinking that the buyer is really just pre-paying part of the down payment with the earnest money, you’re right. So what’s the issue? Why would the buyer be concerned with losing the earnest money? Why would the seller really care how large the earnest money deposit is?

Those questions all come into play when the contract goes south, and the buyer decides — for whatever reason — to break the contract and walk away. Remember, the buyer and seller promised each other they would work toward getting the property sold. The buyer backed up his word with the earnest money. If the buyer walks, the seller generally gets to keep the earnest money. The circumstances under which this would be true will of course be spelled out in the contract, so remember, always read the contract and know what it says.

As always, keep in mind that I am not a lawyer. This information is for general education only, and is not intended to be legal advice. If you need legal advice about your particular case, please contact an attorney.


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