Let's Consider Earnest Money

Posted on: June 27, 2007

When prospective buyers decide to pursue the purchase of a house, they are expected to pledge something of value to demonstrate that they are “in earnest.” Although anything of value can be pledged (jewelry, automobiles, a goat once!), the traditional means are via a check or promissory note. Valuable consideration is the glue that holds transactions together. In fact, years ago the purchase agreement was referenced as the “Receipt for Earnest Money and Agreement to Purchase.” As you can see, the emphasis was on the receipt of the earnest money. The terms of the agreement were almost an afterthought.

As deposits go, my personal preference is a promissory note. From the standpoint of a Broker/Owner, it is a much easier instrument to handle. Cash is dangerous once it’s been receipted for. Checks generally need to be deposited right away. As a business practice, I have to wait 10 days to make sure that the check clears before I issue a refund. If buyers make an offer which is immediately rejected, they are standing on my doorstep expecting their money back. This is not a distraction that I need.

Promissory notes are considered legal tender in the eyes of the law and can be locked away until redemption or returned immediately should the offer be rejected. Most of the notes I see are redeemable within 3 days of mutual acceptance. On occasion, I see a transaction that calls for the note to be redeemable upon closing. Depending upon the whims of the buyers, closing may never occur. These notes are not considered legal and a real deposit should be made a part of the sellers’ counter-offer.

Once collected, the earnest money deposit is generally placed in a neutral escrow account. (This may vary according to your local marketplace.) The deposit is held subject to the terms and conditions of the sale, such as the buyers’ ability to qualify for a loan, the appraisal amount, condition of the title, etc. Should the transaction fail to close through no fault of the purchasers, the earnest money is usually returned in full. In the event of a violation of the terms and conditions of the deal, such as bad faith on the part of the buyers, the earnest money may be forfeited to the seller as liquidated damages and all parties can go about their business. Forfeiture of the deposit should be the limit of the buyers’ liability.

There are no standard earnest money amounts. Whatever is acceptable to the buyers and sellers will suffice. Occasionally, an overzealous broker will make demands of the purchasers, but the final sum has always been a matter of negotiation. My experience has been that a sum equaling one to two month’s of the buyers’ new payment should be adequate. The deposit is intended to compensate the sellers for the inconvenience of taking the home off the market pending closing. In some instances the sellers’ inconvenience is minimal. If brought before a local municipality, too much earnest money might be viewed as an unrealistic penalty and a portion could be returned to the buyers.

Often, novice buyers feel that they have to provide the down payment and closing costs in addition to the earnest money. The earnest money is applied to these costs. As such, a stronger earnest money deposit does not deplete the buyers’ resources and can be used as a demonstration of serious intent. In the event that there is more than one offer on a property, a larger earnest money could be the deciding factor in who gets the deal.

I have successfully sold properties for over 30 years in the Portland, Oregon marketplace. I can say with authority that the forfeiture of earnest money is rare. A competent broker, suitable forms, and a correctly worded agreement are the buyers’ best protections against losing a deposit. On the other side of the equation, a realistic amount pledged can hold buyers to a transaction and protect the sellers against taking property off the market needlessly.