Using Earnest Money Deposits For Buying Houses
How big of an earnest money deposit should those buying homes really be putting down? Perhaps even more importantly, who should it really be deposited with?
There are many myths surrounding the earnest money deposit. Confusion and misinformation results in a lot of controversy and can be very frustrating to the many parties involved in the process. So what’s the real deal? How much should be put up as an upfront deposit? When should it be done? Who should hold the money, and how can home buyers and real estate investors minimize risk in the process?
Deposit ‘rules’ vary greatly between various locations. They aren’t usually based on real estate law at all, but rather how the market has evolved overtime, and has been shaped by real estate agents. This is why many can find what they experience in practice is different from what they learned in real estate school, licensing classes, and real estate investment books.
Common Earnest Money Deposit Practices
While these practices can vary across the United States, perhaps the most common process is for home buyers to make a flat fee or percentage based deposit when making an offer on a home, or once their offer has been accepted. This may be $500, $1,000 or 1% of the purchase offer.
Growing Out of Control
In hot housing markets the earnest money deposit has clearly grown out of control. This started when the U.S. housing market began to heat up in the early 2000s. Some of these ‘rules’ became tradition in some markets. Investors and home buyers should expect demands to get more out of control in some tight markets, as the new real estate boom grows.
In South Florida for example; many Realtors try to demand home buyers put down in the region of 1% to 3% of the purchase price as an upfront deposit when the purchase offer is made. Those claiming to be cash buyers or that state they will be bringing most of the purchase price to the table in cash could be asked for far more in deposit money.
The reasoning is obvious: whether it is looking out for their clients, or their own commissions, real estate agents like to see buyers locked in to the deal. They know buyers will work a lot harder, and will be far more likely to do whatever it takes to make the deal work if they have a lot more money on the line. In some cases, it pushes the boundaries to the extreme, and could be unwise for buyers to engage in. If the success of the deal depends on mortgage financing or an inspection with minimal repair needs, buyers need to be aware of the risks.
Bad for the Market?
Obviously sellers and their agents have the right to determine whatever terms they like. They can demand only cash offers, and 25% deposits if they choose, and they often do. However, there is no question that on a large scale this can be damaging to the market. It can keep a lot of buyers out of the market and bar them from buying homes, even if they would qualify for a home mortgage.
A bigger concern is when these deposits are lost. When deposits are seized or locked up and burned in legal battles, the buyers lose, the sellers lose, and the industry loses. People will get burned out and tired of gambling money on making offers if they continue to lose money. For real estate investors, this may need to be factored in as the cost of doing business, but doesn’t mean that exposure shouldn’t be kept to a minimum.
The Real Deal on Deposits
The practice of making earnest money deposits stems from real estate and contract law stating something needs to be given in ‘consideration’ to make a contract legally binding. Some real estate and legal experts argue that $1 or even the contract itself, or end purchase are all types of consideration. Many very successful real estate investors make it a principle never to make deposits, and do well at it. So technically deposit may not be necessary, and any experienced investor knows that simply making a deposit is not going to help keep a seller in the deal if they want out.
Reducing Exposure to Risk
Fortunately there are many ways for home buyers to minimize risk when they do make deposits. They should be writing in enough contingencies to cover themselves when making offers. It should also be noted that it doesn’t always have to be their personal cash used either, unless required by a mortgage lender. Know this upfront and document the paper trail just in case.
Those seeking to make lower, or no deposits, may more carefully select the areas they are buying homes in, look to work with other investors who understand their situation, work with motivated sellers, or bid on HUD homes.
It is also possible to break your deposit into pieces for lowering risk, and making it more affordable. This can be two or three phases defined by a certain amount of days, or milestones such as inspecting the property. Or just close faster.
Perhaps most important of all is who you deposit with. Remember it is your choice. In fact, it is illegal to be forced to use a specific title company. Transactions can go smoother when the title company or attorney already has a good working relationship with the mortgage lender or Realtor, depositing with the seller’s Realtor or title agent can be riskier.