Wednesday, August 1, 2007

The Importance of Earnest Money

What is Earnest Money anyway?  And what's the purpose of it?  And how much is necessary?  I get these questions quite often.  The first two questions are pretty easy to answer.  The third however is not so easy and depends a lot on the individual situation.

Key To Your HomeFirst of all, what is earnest money?  Earnest moeny is a deposit put forth by the buyer in a transaction to show the seller that they are committed to buying their home and in part to show that they have the financial where-with-all to complete the transaction.  The larger the earnest deposit the more a seller will be comfortable with taking their home off the market while they both do what's necessary to complete the transaction. 

Secondly, what is the purpose of earnest money?  The purpose of earnest money, as I touched on a little bit above, is to show the seller that the buyer is committed to the transaction and to ensure that if the buyer breaches the contract the seller will be compensated for their lost time on the market and to cover any expenses incurred during the escrow period.  The larger the earnest deposit the better a buyer appears to be positioned to complete the transaction.

And thirdly, how much of an earnest deposit is necessary?  This is the question to which there is no hard and fast rule.  The bottom line is that as a buyer you want the earnest despoit to be large enough to make the seller feel that your offer is a good one.  As a seller you want to make sure that the earnest deposit is as large as possible to help protect yourself in the event the buyer breaches the contract.  As a seller's agent, I like to see at least 1% of the offer price.  As the buyer's agent, I try to analyze the whole situation to determine what is the least amount of my client's money will need to be on the line in order to make the seller feel comfortable with the offer that I am presenting.  In markets like we are in now, where the buyer, in most cases, has some leverage, we are able to offer earnest deposits that are a little bit lower than normal.  In the markets of 2003-2005, buyers were forced to make as large of an earnest deposit as they financially could in order to persuade the sellers to take their offer over another buyer's offer.

And what happens to the earnest money?  Once the offer is accepted the funds are deposited with the title company and held in a trust account.  If all goes as planned throughout the transaction, the deposit is applied towards the buyer's down payment and/or closing costs.  If the buyer elects to cancel the contract due to an agreed upon contingency in the contract (home inspection, finance, sale of the buyer's current home, etc) the buyer is refunded their earnest money.  However, if the buyer elects to cancel the contract, or breaches the contract, the seller may have the right to the deposit.  Breaches of contract very rarely occur, but when they do it is very important that the seller has negotiated up front for the largest earnest deposit possible.

It happened to me and my client this past month.  We received a contract with an earnest deposit of 1.5% of the offer price.  In this market where buyer's are at an advantage, we were very happy with the amount of the earnest deposit.  The transaction when along as smooth as we could have expected.  We were one day before the scheduled close of escrow and the buyer's agent called to inform me that the buyers have decided that due to an unexpected change in their financial situation and income of their business, they were unable to purchase my client's home.  After making a few phone calls to discover that due to the buyer's very strong financial history, their loan had already been approved and was not dependent on their income, we then determined that the buyer was going to be breaching the contract and forfeiting their earnest deposit.  The buyer's did finally make the decision to cancel the contract and my clients, the sellers, were awarded the earnest deposit as damages for the breach of contract.  In the end my client would have much preferred to have the house sold, but due to the substantial amount of earnest deposit offered by the buyer, they were protected.

-Steve Nicks

[tags] Desert Ridge real estate, Phoenix real estate, earnest money [/tags]