Thursday, December 4, 2008

Earnest Money

money-under-magnifying-glassWHAT IT IS


Earnest money is the amount of money a buyer submits with an offer to purchase a house. You actually write a check (or a copy of the check) and send it with the purchase offer.


Earnest money proves the buyer is 'in earnest', or serious about buying that house. If the seller accepts the offer, the earnest money is immediately deposited with the escrow/title office. It becomes part of the purchase price of the house.


A personal check is usually acceptable for earnest money.


Working with a lot of Canadian investors lately has taught me that many Canadians call it the "Deposit".



HOW MUCH IS RIGHT?

A really common question I'm asked by buyer clients (especially first time buyers) is, "How much earnest money is the right amount?"

Technically, I'm not supposed to tell you. At least that's what I remember from my rookie training classes. If I'm remembering correctly, I think this was a rule dreamed up by the legal eagles in our profession. They worry that if Realtors simply tell clients what to offer, how much to put down, how much earnest money to offer and so forth. . . . well, we're essentially price fixing and could be sued later by disgruntled buyers who are having buyer's remorse.


I used to be a paralegal and have lawyers in the family, so I'm pretty ultra-sensitive to the myriad of ways agents get themselves sued. Since I like to keep on the right side of my company's legal department, and since I haven't got a brass farthing worth suing me over, I won't state a 'proper' earnest money amount here.


But it's typical to put 1% to 2% of the purchase price up as earnest money.


HOW MARKET CONDITIONS CHANGE EARNEST MONEY


2005 and early 2006 were boom-boom years in the metro Phoenix real estate market. Sellers received multiple offers after only days or hours on the market. Sale prices were frequently above list price, and buyers often waived many of their usual inspections and contingencies just to secure the house. This is an extreme seller's market.


In a seller's market earnest money often amounts go up. Buyers are competing against each other to buy the few properties available and increase their earnest money and/or down payments to make their offer look better than others' offers. I commonly saw earnest money amounts in the tens of thousands. It wasn't unusual to see earnest money amounts that were 4% or 5% of the purchase price, or more.


Today we're in an extreme buyer's market. In many cases earnest money amounts have dropped as a result. I've recently seen purchase offers for average priced homes ($200,000 to $300,000-ish) with earnest money of only $1,000 (that's less than 1%).


Properties that first time buyers typically buy (condos, any property under $125,000-ish) often bring earnest money amounts at $500 and under. Some cash-strapped first time buyers using FHA loans even ask that earnest money be refundable at close. They often apply that money to the closing costs. (see more about buying with little or no money down here.)


EARNEST MONEY EXAMPLE


For example: Buyer looks at a house with an asking price of $299,900. Buyer makes an offer of $280,000. That $280,000 is made up of - (1) $3,000 earnest money, (2) $40,000 cash down payment, and (3) a promise to get a home loan for the remaining $237,000.


RULE OF THUMB


One rule of thumb about earnest money is, "put up as much earnest money as you can afford to risk." The risk bit is important. Earnest money is forfeitable if the buyer breaches the contract. In plain English this means that if you, the buyer, back out of the purchase after your Due Diligence period, the seller has the right to keep your earnest money as compensation for the lost time on the market.


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