Earnest Money - How Much is Enough?

The sale of a property can be divided into the following phases:
- Contract Negotiation
- Option Period
- Post-Option / Pre-Finance Period
- Post-Finance Period
- Closing

Regardless of the state where you are located and the specific form of the contract the purpose of the Option Period is to allow the Buyer to inspect the property and determine if they want to proceed with the purchase. During this period the Buyer can terminate their offer to purchase if the Seller refuses to make the repairs that the Buyer deems necessary. If the Seller refuses to make the repairs that the Buyer requests, of if the repairs are more extensive than the Buyer is comfortable with, the Buyer can terminate the Contract and get their Earnest Money back.

Most Buyers will need financing and most Contracts to purchase a property include a 'Third Party Financing Addendum'. The Third Party Financing Addendum allows the Buyer time to apply for and obtain financing. If they are unable to obtain financing they can get their Earnest Money back. Typically, the Third Party Financing Addendum will allow the Buyer 14-21 days to obtain financing approval for the purchase of the property.

Once the Third Party Financing Addendum 'approval period' has expired the Buyer does not have any contractual right to receive a return of their Earnest Money and if they fail to close they will forfeit the Earnest Money to the Seller. The best insurance that the Seller has that the Buyer will perform on the Contract and complete the closing process is to require that the Buyer put a significant amount of Earnest Money into the purchase of the property.

What is a significant amount of Earnest Money? The answer to that question is based on pain. I suggest that the amount of the Earnest Money that is signficant is an amount that is based on the price of the property and the risk that the Seller is taking. Generally, the Earnest Money should be about 1% of the Sale Price, ranging from a low of about .5% and a high of about 1.5%. If the Sale Price is $100,000 the Earnest money should be no less than $500 and probably not any more than $1,500. If the Sale Price is $500,000 the Earnest Money should be no less than $3,000 and probably not any more than about $7,500.

Where on the range from .5% to 1.5% the Earnest Money amount falls is dependent upon the particulars of the contract and the probability of successful closing and the rist to the Seller. If the Buyer is very qualified and the closing will be quick the amount of the Earnest Money can be reduced to the lower end of the range. If the Buyer is asking the Seller to wait to close longer than about 30 days the Earnest Money should be increased. If the Buyer is wanting the Seller to reduce the price signficantly and wait a long time to close then the Earnest Money should be at the high end of the range, and possibly even a little above the range.

The Seller is taking a big risk by accepting a contract. The Seller is taking their home off of the market and during the Option Period or Finance Period their home will no longer be shown to prospective Buyers by other Agents. This removes the potential of back-up contracts and offers. If the Seller accepts a contract during April that does not close until June the Seller is losing a whole month of 'prime-time' for selling. That is a big risk that the Seller is taking and the Buyer should be making a signficant investment in the purchase to offset that risk.

Many variables should be considered and they must all be given the proper weight based on the particulars of the Seller and Buyer. Here is a quick list of the variables that must be considered by the Seller when determining how much Earnest Money is required:
- Sale Price
- Down Payment
- Creditworthiness and Loan Pre-approval
- Time to closing
- Time of year
- Days on market
- Alternative properties and relative price
- Cost of not selling
- Urgency to sell
- Risk threshold

Ultimately, you want to collect enough Earnest Money that the Buyer will not 'walk-away' from the deal without suffering signficant pain, or at least enough that you, the Seller, can receive some reasonable compensation for the fact that your home has been taken off of the market during the Contract period prior to the default of the Buyer. Keep in mind that the ability to recover the Earnest Money is not a foregone conclusion even if the Buyer defaults and that it may take many months to receive the Earnest Money and that to facilitate the receipt of the Earnest Money you may end up negotiating to accept only a portion and release the remainder to the Buyer.

If you have any questions about this article please call Lee Thurburn at 972-470-5888.

Offer vs Sale Price - Negotiation Thoughts

Between October 2004 and May 2006 I have listed over 1,000 homes and been directly involved in the sale of over 600 homes. As a result of my experience I have developed a couple of 'rules-of-thumb' that can help you to know what to expect and how to negotiate the best deal.

For the sake of this article lets say that the following is true:
- Current List Price = $300,000
- Initial Offer Price = $270,000
- Mortgage Pay Off = $255,000
- Cash Needed by Seller at Closing = $10,000
- Buyer's Agent Commission = 3%
- Title Insurance Policy = 1%
- Other Closing Costs = $500

I find it useful to take the difference between the Current List Price and the Initial Offer Price and divide that amount into equal thirds. I have found that the probability that the Buyer will come up 1/3 of the difference is at least 80%. If have found that the probability that the Buyer will come up 2/3 of the difference is about 20%. I have found that the probability that the Buyer will come up 50% of the difference is less than 50%.

In the above example the Buyer will almost certainly (80% probability) be willling to come up by $10,000 to about $280,000. It will be progressively more difficult to get the Buyer to come up more than that amount.

Obviously, as the Seller you will want to maximize your price. It is important to know what your 'Minimum Sale Price' is before you enter into negotiations. There must be a point where you will walk away from the deal and you should know what that point is before you start to negotiate with the Buyer.

I have found that there is a tendency for the Seller to adjust their 'Minimum Sale Price' as they get involved in negotiations. As you invest the time and the emotional energy into the 'deal' you have a tendency to want to make sure that the deal gets done. There is also a growing sense of 'last-chance' that often developes. As the Seller you will often be ready, emotionally and financially, to move on and to leave the old home for the new life that is around the corner.

Finally, there is a phenomena that exists related to the 'Buyer Pool' and the level of 'maturity' of the Buyer Pool that impacts the sale process and the decision related to the sale. Lets discuss that in a later BLOG.

If you have a Minimum Sale Price based on your mortgage and a desired (required) minimum amount of additional cash that you need to come away from the sale with you take that number and 'gross-up' to the required Sale Price to achieve your Minimum Sale Price. Lets take the Mortgage Pay Off plus the Cash Needed by Seller at Closing which totals $265,000. Since the Other Closing Costs will increase the needed Cash by $500 the Cash Need by Seller at Closing becomes $265,500. The total Commission and Title Insurance cost is 4% of the sale price. To determine the Minimum Sale Price take the Cash Neede by Seller at Closing and divide by 96% to get the 100% number.

$265,500 / .96 = $276,563

In the situation defined by the above any Sale Price above the $276,563 will net the Seller the cash that they require out of closing.

You can adjust the above $ amounts and use your particular transaction details to come up with the same numbers for your deal.

Seller Financing Issues

It is very common for the Buyer to ask the Seller to finance a portion of the sale price of a home. With rising interest rates this will become even more common. I am not talking about the situation where the Seller provides down-payment assistance but rather where the Seller actually carries a note for a portion of the sale price.

I generally recommend that Sellers try to avoid providing financing assistance because of the simple fact that the primary mortgage lender will be the primary lien holder and if the Buyer defaults on the primary morgtage the primary lender will get their money first. They will generally have the legal right to sell the property to recover their loan without requiring that they attempt to get more than the amount to cover their loan. They can foreclose and sell at auction or under foreclosure and the amount that is recovered will usually be just enough to cover the primary lien.

As the Seller your secured position will be secondary to the primary lender and if a default occurs by the Buyer the value of your note could become $0 because the foreclosure price may not be sufficient to cover any of your lien in which case your note is worthless. Your only course of action would be to purchase the lien from the primary lender and then sell the property yourself. That would not normally be a very tenable situation and is not typically what happens.

If you are considering financing the full purchase price of the property that is a different issue since you become the primary lien holder and you have much greater control over the property. As a secondary lien holder you may find that the value of the property has been dramaticaly diminished due to the Buyer's lack of care of the property and the equity difference between the primary lien amount and the value is not sufficient to satisfy your lien. As a primary lien holder you have more control over the timing of events and can often structure your lien and mortgage to give you the right to act more quickly than most large mortgage companies can act thereby allowing you to initiate preventative action to protect your asset value before it is irreperably damaged by the Buyer.

If you are considering carrying a Seller Second be sure that you are able to suffer the loss of the entire finance balance since the concerns above are very real and the worst does often happen.