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Thursday, October 14, 2010

Earnest Money: When More is Less

Law of Diminishing Returns

If you don't like technical, legalistic real estate posts -- stop reading here.

Earnest money (called "unrest money" by at least one recent Buyer) plays an overlooked but critical role in every real estate deal.

Typically 2% to 5% of the purchase price, given by the Buyer to the Seller as part of the offer, earnest money actually accomplishes two things: 1) it establishes the Buyer's financial bona fides and commitment to the deal (think of it as the "down payment on the down payment"); 2) it serves as what lawyers call "liquidated damages" if the deal goes south.

In layman's terms, it is an upfront, agreed-upon estimate of what the Seller's damages will be if the Buyer fails to close (typically, for lost market time).

In other words, if the Buyer walks, the Seller keeps the earnest money, and both parties move on.

Theory vs. Practice

Except that in practice, earnest money can become a bitter bone of contention.

That's especially the case if the Buyer feels the Seller shares responsibility for the deal not closing -- and the earnest money is unduly large.

Then, instead of simply forfeiting the amount and walking away, the Buyer may decide that it's worth fighting over.

They can threaten litigation; refuse to formally cancel the deal, which prevents the Owner from selling to anyone else (and can then require that the owner go through the hassle of obtaining a statutory cancellation to get free of the Buyer); or cause various other mischief and headaches.

Ironically, in the rare instance when one of the foregoing scenarios occur, Sellers belatedly realize that the hefty earnest money check that was supposed to protect them instead can mire them further in a mess.

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