In nearly every real estate purchase contract, the seller will require that the buyer deposit earnest money—a sum of money that the buyer puts into trust during the transaction to demonstrate good faith. The earnest money amount is often dictated by the seller, and can be a flat price or a percentage of the purchase price.
The purpose of earnest money is to provide the seller with compensation in the event that the buyer backs out of the deal through no fault of the seller and in violation of the agreements in the purchase contract. This article will discuss the instances where the seller will be able to retain the earnest money, as well as the circumstances under which the seller must return the earnest money to the buyer.
Home purchase contracts will have many contingencies and deadlines laid out for meeting certain milestones in the purchase process. All of these deadlines can be negotiated by the buyer and seller, and it's important to think through what might be the appropriate amount of time required to meet each deadline, since once a deadline is listed in the contract, there is no requirement that either party be flexible about changing it.
At nearly each of these deadlines lies an opportunity for the buyer to back out of the contract without forfeiting the earnest money, so long as the buyer submits timely, appropriate notice of the intent to back out.
For example, one of the most common deadlines where earnest money can be at risk is the inspection contingency deadline. In the contract, the buyer should negotiate a date far enough out to allow for all desired home inspections to be made. If, during those inspections, the buyer discovers something about the property that he or she cannot live with, the buyer will nearly always have the option to drop out by the deadline. So long as the buyer does so with timely, proper notice, the seller must promptly return the earnest money and move on with marketing the home to other potential buyers.
However, if the deadline has passed and the buyer discovers something else about the house that is objectionable, and drops out of the contract, the seller will likely have the option to keep the buyer's earnest money.
Other common deadlines at which the earnest money is on the line include title review deadlines, deadlines to review all documents relating to the property, and—this is a big one—a loan contingency deadline.
More often than not, it is after the loan contingency deadline when the buyer's earnest money goes “hard,” or non-refundable. Because securing a loan can take awhile, the loan contingency deadline is often the final deadline in the contract, and is the last “out” for the buyer. If a buyer decides to not purchase the property after this deadline, it is likely that the seller will have the right to retain the earnest money.
The earnest money can be held in escrow during the contract period by a title company, lawyer, bank, or broker—whatever is specified in the contract. Most U.S. jurisdictions require that when a buyer timely and properly drops out of a contract, the money be returned within a brief period of time, say, 48 hours.
It is prudent for the buyer to contact the escrow holder to let them know of the need to release the money. Buyers should check with their broker or the laws applicable in their area to see if a specific form is required to be submitted to the escrow holder, and whether that form needs to be signed by all parties to the contract prior to the release.
In the event a dispute arises over whether the earnest money should be returned (for example, if the seller argues that the buyer did not notify the seller in a timely manner of the intent to back out of the contract), the escrow holder will continue to hold the earnest money until the dispute is resolved. Most of the time, if there is even a hint of a dispute, the earnest money will be retained by the escrow holder, simply to protect the escrow holder from any liability.
The purchase contract is the first resource to consult when a dispute has arisen over whether earnest money should be returned to the buyer. The terms of the contract will govern the parties' next steps. Often, the contract or state law will require that the parties attend mediation or arbitration before anyone can bring a suit to recover the money.
The home buyer and seller should also consult with the entity or person holding the earnest money and inquire as to what its procedure is in the event of a dispute. Most likely, the escrow holder will have a standard procedure or at least some advice about what happens next. Many states have specific, systematic laws about how escrow holders must handle disputes over earnest money. Parties to a dispute will need to become familiar with these laws.
It's also a good idea to consult with an attorney about your escrow money dispute, especially one who is good at negotiations. Almost no one is going to want to take the matter to court—it is probably in everyone's best interest to at least explore the possibility that there has been a misunderstanding or that a compromise can be reached.
Whether you are a buyer or a seller in a dispute over earnest money, keep in mind what the purpose of the earnest money is to the other side: for the buyer, the money was put forward to secure a right to purchase and show good faith. For the seller, the money was put forward so as to be assured of compensation for any time lost by taking the property off the market for the benefit of the buyer.
Unfortunately, there will be times when the parties exhaust their pre-litigation options or requirements and cannot reach an agreement over the distribution of the earnest money. At this point, the matter will have to be decided in the courts.
If the amount of the earnest money is small enough, small claims court could be an option, depending on your state's criteria and monetary limits for these courts. Otherwise, a court of general jurisdiction will be able to hear and resolve the matter, but it will likely be a longer process during which neither the buyer nor the seller will have access to the earnest money funds.
The moral of the story is: As a buyer, be diligent about your home-purchase-contract deadlines and always give proper, timely notice (per the purchase contract) of any intent to drop out.
As a seller, be aware that you will not automatically get earnest money if a buyer drops out, but you may be entitled to it when a buyer is in breach of the terms of the contract and does not complete the purchase.