What is the Right Amount of Earnest Money?

Legal Hotline Lawyer Annie FitzsimmonsLegal Hotline Lawyer Annie Fitzsimmons
Before we can address the question of determining the right amount of earnest money, we have to start with a clear understanding of the purpose for earnest money—what it does and what it does not do.  First, earnest money is not consideration.  We all learned in our first real estate class that every contract requires an offer, acceptance, and consideration.  The consideration that supports a real estate purchase agreement is the mutual exchange of promises.  Buyer promises to buy and seller promises to sell.  Earnest money is NOT consideration.

Earnest money simply funds the liquidated damages provision.  If buyer defaults, seller is damaged.  Seller had the property off the market during the pendency of the agreement; seller vacated the property in anticipation of closing, seller made improvements to accommodate buyer, etc.  As a result, when buyer defaults, seller is entitled to a remedy.  

Learn more about Earnest Money in a competitive marketplace in this video...

For seller to gain relief in the absence of a liquidated damages provision, seller must sue buyer and prevail in court by proving the amount of damages seller suffered.  Depending on market conditions, seller’s damages and thus buyer’s exposure can be significant.   But a court action is, of course, a time and resource draining experience that most residential sellers (and buyers) cannot endure, even if seller has proof of substantial damages.

To provide sellers a speedier remedy and to cap the exposure a defaulting buyer may face, the industry, generations ago, instituted the concept of earnest money…liquidated damages.  An earnest money provision is a liquidated damages clause entitling seller to the earnest money in the face of buyer’s default. Thus, in the statewide purchase agreements, there is a negotiated provision entitled “Default.”

Within the “Default” provision, buyer and seller must agree that if buyer defaults, seller will either retain buyer’s earnest money as seller’s sole and exclusive remedy or seller will be entitled to sue buyer for actual damages and/or specific performance. (Specific performance means that seller sues buyer with the goal of forcing buyer to complete the purchase.) If the parties agree to “Forfeiture Of Earnest Money,” then in the event of buyer’s default, seller is entitled to retain the earnest money without proof that seller suffered any damages and buyer cannot be required to pay more in damages than the earnest money.  If the parties agree to “Seller’s Election of Remedies,” then seller may sue buyer for actual damages and/or specific performance.

So, with this background, what is the right amount of earnest money?  The first answer is that there is no “one-size-fits-all” answer to this question.  There is no formula for calculating earnest money that can be applied to every transaction.  The right amount of earnest money can only be determined in light of the terms of the transaction.

From the seller’s perspective:

If the sale is scheduled to close in 15 days, all cash and the house is already vacant, the earnest money could be low or even nothing at all.  Seller’s maximum loss is 15 days of marketing time.  However, if the sale is scheduled to close in 120 days and seller must vacate early and replace flooring throughout the house with hardwood to accommodate the highly allergic buyer, then seller should demand substantial earnest money.  Seller risks losing four months of marketing time, the expense of vacating and enormous loss associated with changing the flooring, if buyer fails to close.  

The typical transaction, of course, falls somewhere in between these extremes. Listing brokers must be able to understand the significance of buyer’s offering terms to properly counsel seller regarding the “right” amount of earnest money.  If the seller intends to agree that seller’s remedies will be limited to forfeiture of earnest money, then the amount of earnest money is a significant term.  Too often, brokers skip over the amount of earnest money, believing that it is rare when a seller is able to keep the earnest money.  While that is a true sentiment, it does not justify a listing broker’s failure to counsel a seller with respect to earnest money.  

If seller’s remedies are limited to forfeiture of earnest money and if the earnest money is insignificant, there is no risk to buyer for defaulting, making default an easier and more likely outcome.  When seller’s remedies are limited to forfeiture of earnest money, seller must be educated to understand the significance of the earnest money and assisted to determine the righ``t amount of earnest money.  Calculating the “right” amount of earnest money should take into account the seller’s anticipated losses in the event buyer defaults at or prior to closing.  

From the buyer’s perspective:

Whatever the amount of earnest money, buyer stands to lose it.  Naturally, the typical buyer wants the earnest money to be the smallest amount possible.  Buyers should be counseled to set earnest money in conformity with the competitiveness of the market place and the competitiveness of the remaining terms of buyer’s offer. If buyer is lowballing seller’s price, buyer may want to increase the earnest money to make buyer’s offer more desirable and to compel seller to believe that buyer fully intends to close the transaction.  In a strong seller’s market, buyer may want to increase earnest money to distinguish buyer’s offer from the expected, competing offers.  However, in a buyer’s market, where seller is simply grateful to receive an offer, buyer may have no reason to put a large earnest money at risk.

Earnest money is a negotiation tool to be used by both parties in the negotiation.  The savvy broker understands the significance of earnest money and is able to counsel broker’s client to effectively use earnest money as a negotiation tool.  A buyer who puts down less earnest money could be signaling less commitment to the transaction.  If buyer wants to overcome that message, then perhaps buyer with a weak earnest money should mark the “Seller’s Election of Remedies” box rather than forfeiture of earnest money.  In that case, seller must be made to understand the difference in forfeiting earnest money as opposed to pursuing a lawsuit to prove damages.  Very few sellers will actually file a lawsuit and pursue a damages remedy.  Brokers on both sides of the transaction must understand these nuances in order to properly counsel a client.

It is understood that this entire issue is clouded by the difficulty sellers experience in recovering earnest money that should be forfeited to them and by the frustration buyers experience when earnest money they are entitled to recover is denied to them by a recalcitrant seller. Notwithstanding these difficulties, earnest money is part of the statewide purchase agreements and an expectation of most buyers and sellers. Therefore, earnest money is a negotiating tool in nearly every transaction.  Setting the right amount of earnest money is always fact-dependent and the client always has the final say as to the right amount of earnest money.  However, brokers must understand the subtleties and strategies of effectively using earnest money so that the “right” amount of earnest money can be recommended and explained on a case-by-case basis.

Hotline Attorney Annie Fitzsimmons writes the Legal Hotline Question and Answer of the Week.  If you’d like to submit questions to the Legal Hotline, e-mail them to legalhotline@warealtor.org or call (800) 562-6027. Please have your NRDS number ready when you call or e-mail the Hotline with your question.  The Legal Hotline lawyer does not represent Washington Association of REALTORS® members or their clients and customers.

You are not allowed to post comments.