What Is Earnest Money

I’ve found that many folks involved in real estate transactions, especially first time buyers and sellers, are not really clear on what earnest money is and how it’s dealt with. In what’s often one of the largest financial transactions of your life, it’s critical you understand the details of every dollar risked or spent and earnest money deposits are the leading edge of the deal.

What is Earnest Money?

Earnest money is typically cash passed from the buyer to an escrow agent to be held in trust as a performance guarantee in real estate deals. It’s sometimes confused with a loan deposit. In mortgage situations, buyers often have to pay a percentage of the sale price in order to get a good interest rate or avoid mortgage insurance. Ernest money is not part of that. It has nothing to do with the loan process, although in some cases lenders will require proof the earnest money was paid as part of evaluating the borrower’s debt and income.

I’ll often refer to it as a “deposit” from here on. For this article earnest money and deposit are interchangeable.

Earnest money is usually a percentage of the selling price of a property, though in Albuquerque it’s often less than 1% of the negotiated home price and is often treated as a default amount – say $500 or $1,000 – regardless of the purchase price.  Earnest money is always a negotiable item. When I represent a buyer, I work to keep the amount low, since that’s money put at risk. When I’m representing the seller, I work toward a higher amount, since it’s money guaranteeing buyer performance.

The purpose of the deposit is to show that the buyer is serious, or “earnest”, about purchasing the property.  It shows a level of commitment to the sale and is a way for the buyer to show they’ll act in good faith during the escrow period. It’s something the buyer is putting at risk and if they do not perform their end if the deal, it’s money the seller may keep.

Earnest money does not need to be cash. An earnest deposit can be made in the form of a promissory note. A buyer may sign a document that promises to pay a certain amount if the deal does not close. The obvious issue with a note is collection and so this is fairly rare.  It can also be a car, a cow or a piano. It can be barter goods or services. Basically it’s anything the buyer and seller agree has value and will guarantee fair performance on the buyer’s part. Remember, all aspects of a real estate deal are fully negotiable and nothing is set in stone.

When it’s part of a negotiated agreement, the deposit is defined in amount, type of payment (cash, check, wire, etc) and due date. If the deposit is not made correctly, the buyer has defaulted and the contract can be considered void. In fact, if the deposit is made incorrectly but still made, the default might be considered grounds for both voiding the agreement and the seller retaining the deposit.

A picture of a house made of money

Where Does Your Earnest Money Go in Albuquerque?

All things real estate are negotiable, right? So where the money goes is decided by the buyer and the seller. That said, local convention often dictates handling and buyers and sellers often do whatever their brokers suggest.

Earnest money is typically due and payable upon the final execution of the contract – when all the parties have reached an agreement and signed off.  Often, it’s collected from the buyer and held in a broker’s hand during negotiations. Since a broker must deposit funds belonging to others (the buyer, here) in an institution promptly, if negotiations are going to take more than a day or two, the money will need to be put into a formal escrow account or retained by the buyer. Regardless, if you are a buyer, you should ask exactly what will happen to that deposit when you hand it to your broker. If you are a seller, you should ask if a deposit exists and where it is.

The broker will park the money in their own brokerage trust account, a specified escrow company’s account, or with the title company handling the transaction.  In Albuquerque real estate deals, almost all earnest funds are handed to a title company, most of which act as escrow companies as well. One way or another, unless otherwise agreed to by both parties, the money needs to be placed in an institutional escrow account as defined by New Mexico law.

I think the best way to deal with the deposit is to provide for 2 or 3 days time after an agreement is reached for the deposit to be made, and then have it wired directly to the escrow holder. Clean and simple, easily tracked.

What Happens to the Earnest Money When You Close?

Earnest money is almost always applied to the sale at closing. It becomes part of the purchase price. What the buyer pays to the seller at close, whether by cash or loan, is reduced by the amount of the deposit. Section 3 of the New Mexico Purchase Agreement (NMPA) says specifically “Earnest Money shall be applied to Purchase Price, down payment, and/or closing costs.”

Even if you use the NMPA, there are exceptions and I’ve seen cases where the earnest money is returned to the buyer at closing. Typically this happens when the buyers is taking a zero down loan and having their closing costs paid by the seller or the lender, say, in a VA loan or New Mexico MFA loan. In such cases, the deposit is held to guarantee performance, but when the deal closes, it’s returned to the buyer.

What if You Don’t Close?

So what happens if the sale falls through?  Who keeps the earnest money?  As with most things real estate, that depends upon the circumstances.  A carefully written purchase agreement will say clearly what should happen to the earnest money if a deal tanks. Much will depend on whether the buyer and the seller acted in “good faith,” i.e. did what they were supposed to do when they were supposed to do it.

During the due diligence period of a typical contract, the buyer has certain tasks they can and should do to make sure what they’re buying is in agreed on and acceptable condition physically and legally.  Inspections, title searches and surveys, HOA document reviews, etc. are some of the fact gathering and evaluation aspects of due diligence.

Each task, referred to as a contingency, has a deadline for when it’s to be completed and conditions that need to be met to confirm agreed upon standards. If there are issues, when and how those are to be addressed should be spelled out clearly. As these contingencies are met and cleared, the deal is considered to be moving forward. If one of the contingencies is not met and cleared, say an inspection reveals a rotten roof and the buyer and seller can’t agree how to deal with it, the typical agreement allows for the deal to be terminated.

If a buyer terminates a contract based on an agreed to contingency like that roof inspection, as long as it’s been done within the time frame and by the terms established contractually, the earnest money should be refunded to the buyer.

Can earnest money can be lost by the buyer?

Absolutely. If the buyer does not work through their diligence in a timely manner, as agreed, and terminates the agreement, the earnest money can be retained by the seller. Say they found that rotten roof, but they didn’t inspect by the date agreed to. They would lose their right to terminate the deal based on that roof. If they walk away anyway, they can lose their deposit.

I was representing a seller in a deal in the mountains a few years ago. A buyer made an offer based on the usual inspections and reviews. Because of where the cabin was located, they wanted to have a full survey performed. The seller refused to pay for the survey so the buyer agreed to be responsible for it. All of the inspections were fine, but when the survey was done it was found the cabin was within a few feet of the rear property line – too close for the buyer’s comfort.

The buyer had the survey done on time and according to the agreement. They terminated because of what they found, well within the terms of the agreement. They lost their deposit anyway. Why? They refused to pay for the survey as agreed. Since the surveyor might have had the right to lien the property he surveyed rather than chase the buyer for payment, the seller insisted the survey be paid out of the earnest deposit.

Buyer and seller scuffled for a week or two, but the buyer finally relented and abandoned their deposit, which was then used in full to pay the survey. In this case, even though the buyer acted in a timely manner, they were still bound by agreement to pay for what they ordered and so lost the deposit.

Why should the seller keep the earnest money if the sale falls through?

Because it’s provided for in the contract. In the above survey example, the seller didn’t actually keep the deposit, it was used to pay a bill. But there are certainly reasons the seller may be entitled to the deposit.

When a buyer and seller agree on a contract and the deal goes into escrow, the property essentially comes off the market. The escrow period now for most deals in Albuquerque, particularly ones involving a mortgage loan, are often 30 days or more. During that time, the property effectively comes off the market because brokers often won’t show it and it won’t appear on sites like Zillow or Realtor.com

The seller can lose valuable marketing time during the escrow period and if the deal does not close, potential buyers may have moved on to other properties.  The seller may have spent money that hinged on terms of the contract, like paying for an appraisal or survey.  The seller may have made a deposit on a moving van or paid for certain repairs or upgrades that had been negotiated as part of the deal.

Sellers often are buying another property and that purchase is keyed on the sale of their property. They may be spending money as buyers on their own deal for inspections, etc. If their sale fails, money spent on their own prospective deal may be lost.

Of course, all real estate deals have some risk of not closing. Contracts, diligence periods and deposits are all designed, if engineered well, to mitigate that risk. But, if a buyer walks away from a deal without just cause, a seller is entitled to compensation for lost marketing time or other costs.

Seller’s should also know that their brokers may be entitled to part of that earnest money. Though not typical in New Mexico listing agreements, the seller and their broker can agree that the broker will receive part of the deposit if a deal falls through and the buyer forfeits the deposit. This may be seen as compensation to the broker for time and expenses accrued during the escrow period.

What Happens if the Buyer and Seller Disagree on Who Gets the EM?

As in everything in a real estate transaction, this should be spelled out in the purchase agreement or related document. If the standard NMPA is used, it will stipulate who holds the money. If the contract terminates and the buyer and seller can’t agree on who gets it, the holder of the money, usually the title company involved in the transaction, will refuse to release the money until an agreement is signed by both parties.

Per sections 30 & 31 of NMPA, buyer and seller have agreed to first try mediation, where a neutral party tries to work out an agreement. If that doesn’t work or they can’t agree on a mediator, the next step is likely civil court. At that point, the deposit holder may continue to hold the funds until an agreement is reached or a court hands down instructions. While the parties scuffle and before they figure things out, the deposit holder may also “interplead” the earnest money – basically hand it to a court and ask the court to settle it, thus stepping out of the situation.

How Do You Avoid EM Problems?

Obviously, if a deposit becomes an issue, it may be a long time before the issue is resolved and it may be an expensive process. When you enter into a real estate purchase agreement, read everything you sign carefully. Yup, like many states in the good old USA, New Mexico has created long, complicated forms that can be mind-numbing for the uninitiated. Regardless, it’s up to you to read every word and understand your obligations and rights.

Your broker or agent should be able to help you understand most of it, the main issues, but if you have questions they can’t answer, you need to ask an attorney. In fact, it’s perfectly acceptable for your broker to suggest you bring an attorney in. By law, as brokers and agents, we are limited in what we can do to interpret purchase agreements for our clients. If there’s an unclear issue, we are duty bound to refer you to an attorney.

But if you take the time to go over the agreement carefully, it should be pretty clear what you need to do to preserve your rights to that earnest money on either side of the deal. If you are a buyer, you need to perform your evaluations on time and as agreed and work closely with your lender to expedite the loan process. If you find an issue that needs to be resolved before you are comfortable closing the transaction, you need to deal with that issue in a timely fashion as agreed to in the agreement.

If you are a seller, the same thing stands. You need to make sure you provide access and documents as agreed to. If you agreed to have a survey done, for example, it needs to be delivered when and as agreed. If inspections are to be done, you need to make sure fair and reasonable access to the property is given in the time frames stipulated. Documents, like title and HOA, must be delivered on time.

In real estate deals, communication is key. Your broker or agent’s job is to make sure that happens. You need to keep an eye on the calendar and the clock. When an issue comes up, it needs to be dealt with clearly, honestly and swiftly. Modifications to the agreement, if needed, must be made in timely fashion, in writing.

If everyone understands the agreement made, does their part to honor it and acts reasonably and in good faith, there should never be an issue over the earnest money.

I’m happy to go over the purchase agreement and how it addresses earnest money with you in detail. Just drop me a line.

– Joe LaMastra, Realty One of New Mexico, September 4, 2016