What is an Earnest Money Contract?
In the context of real estate, an earnest money contract is a written agreement between a buyer and a seller. It represents a buyer’s intention of purchasing real property, and a seller’s intention to sell that same property. In Texas, the earnest money contract is almost always combined with the various disclosures and other items in the contract and referred to as the contract. In addition to describing the property being sold, the earnest money contract includes items such as the price, the selling terms (i.e. seller financing or not), who is to pay for repairs or inspections, and how long the buyer has to apply for financing, or have the title company complete a title search, to name some common ones .
An earnest money contract would not be considered enforceable if it is not signed by both parties, it fails to accurately describe the property, or if a closing date is missing. The updated Texas real estate contract form provides the following definitions regarding a buyer’s responsibilities: "Closing occurs when …" and "Buyer must …". It is important that a buyer’s offer to purchase a property be submitted promptly. Once the seller has signed the contract it becomes legally binding on both parties. This means that unless the contract contains contingencies for financing, appraisal, and/or home inspections, the buyer is defaulting on the contract if he/she attempts to get out of the contract or to renegotiate the terms of the package. In that case, the buyer may be liable to the seller for damages from his/her default.
Minimum Requirements in Texas
The provisions of the earnest money contract are primarily governed by Texas statutes and common law. They also may be influenced by local customs unique to the area, or even the parties’ own terms and language of a proposed contract as negotiated.
There are only two primary forms of earnest money contract provisions that are mandated under Texas law and specifically provided in Sections 5.008 and 5.0082 of the Rules of Civil Procedure: the form of earnest money contract required when it is for the sale of real estate with a structure to be used as a dwelling and with a purchase price of $100,000 or more; and the language required in earnest money contracts under which a buyer and seller are both represented by a broker in residential transactions where the sale involves property with a price of $500,000 or less. Beyond these two areas, there is still a great deal of contract language, both mandatory and permissive, that is either required under various sections of the Property Code, the Business & Commerce Code, and/or by applicable case law, or which is advisable based on practical considerations or local custom.
For a buyer, these additional provisions often include the following: As with the buyer, these provisions also may be mandated under statutes, case law, or simply based upon practical considerations or local custom: In Texas, a buyer receives a copy of the contract signed by both parties, immediately upon return of the contract. Additionally, Section 22.047 requires that a buyer will receive a copy of the signed earnest money contract for sale of residential property as soon as practicable after both parties have signed. Similarly, a seller is entitled to a signed copy of the contract after he has executed it.
What is the Purpose of Earnest Money in a Sale?
Through their agreement to enter into a real estate transaction, both the buyer and the seller are making commitments. The seller is committing to convey a certain property for a certain price, and the buyer is committing to purchase a certain property for a certain price.
If either party chooses to back out of the transaction, there could be damages to the other party. For example, if the seller backs out, the buyer is now left finding another house, and having to get a loan one are perhaps two more times. Likewise, if the buyer backs out, the seller must continue to market their house and likely pay a second real estate commission.
Given the risk of default, it makes sense to show some good faith that each party is committed to their obligations under the contract. In our Texas residential contract, we use earnest money as a tool to help enforce both parties’ obligations.
Earnest Money generally functions as a deposit of an amount of money (most often $1,000). This check is placed with the title company (or sometimes with the listing broker) at or before closing. If the buyer does not perform their obligations, the seller is entitled to keep the earnest money as their sole remedy (meaning that is the only money that the seller can keep – they cannot sue the buyer for damages, or keep large sums of the money). But sometimes the seller can keep the earnest money, but is not entitled to sue for additional damages – it is contract dependent.
If the buyer does not have the ability to close on the contract (such as a lender denying a loan application), then the buyer may be entitled to a refund of the earnest money, less the option fee amount (if any). Sometimes the option fee amount is the same amount as the earnest money amount (see our post on option period).
If the buyer does fulfill their obligations, the earnest money is applied toward the purchase price at closing.
Just because earnest money is used most often as a deposit, does not mean that it is the only type of deposit. But earnest money is, almost exclusively, a deposit given to a third-party entity to be held in compliance with the contract obligations.
In exchange for the seller putting their home in a position to serve as collateral for the buyer’s ability to close on the sale, the buyer has to put down some form of "good faith" that they intend to be responsible for their contractual obligations. This can take the form of earnest money and/or other forms of collateral such as another contract, pledges of assets, personal guarantees, equity injections, and guarantees.
What is a Typical Amount?
Every Texas real estate purchase contract has a specific paragraph where the amount of initial earnest money to be deposited into the escrow account is detailed. The common amount of earnest money is usually between 1% and 2% of the sales price; however, depending on the agreement of the buyers and/or sellers in consultation with their real estate brokers and/or lawyers, the amount may be more or less.
When a Texas residential real estate transaction is an REO transaction, the lender may have its own form of contract which will contain a provision specifying the amount of earnest money that must be tendered into escrow.
TEA and TAR promulgated real estate sales contract forms are the most commonly used forms in Texas. Under these forms, the earnest money deposit is paid to the escrow agent no later than the 3rd day after the contract is executed. There are some contractual provisions that allow a buyer to terminate a sales contract without penalty if the buyer pays earnest money under the terms of the contract.
In a TEA or TAR promulgated commercial transaction contract, the sale may be deemed to be terminated if the earnest money is not paid within a set number of days after the contract is signed. The parties can negotiate other terms under which the funds can be paid.
Holding of the Funds – Who Has it?
Those familiar with real estate transactions in Texas, have likely heard about an "Escrow". In a Texas real estate transaction, the escrow is an account held by a third person (usually a bank or title company) in which a small amount of money is held as earnest money. This money is put "in third party trust" to assure the buyer and seller that the earnest money will not be taken by either party and is only available to the appropriate parties at the appropriate time. The escrow is usually released to the seller or the buyer, depending on the circumstances of the transaction (e.g. repairs not completed, good faith deposit, etc.).
If your Texas real estate agent introduced you to the concept of an escrow account, they probably mentioned the Texas Occupations Code, Section 1101.550. This section sets forth the requirements of appellant real estate agents for holding earnest money, as follows:
[T]he money that a prospective purchaser or tenant of real property pays as part of an offer to purchase or rent the property shall be paid to:
- (1) a title company authorized to do business in this state;
- (2) a licensed real estate broker who is an agent of the prospective purchaser or tenant; or
- (3) a person identified as the escrow agent in the contract.
The issue of earnest money becomes real when it comes time to produce the earnest money check from your real estate agent. Often this occurs when the contract for sale or purchase of real property in Texas becomes effective. It may also occur when a party attempts to terminate the contract pursuant to its terms (e.g. buyer terminates due to unsatisfactory inspection). The point is that sooner or later a buyer will ask for the money . In effect the buyer is asking your agent to get their money out of the escrow account. If this isn’t done, then the agent holding the earnest money is breaching the fiduciary duty owed to the buyer.
It is important to note that as the buyer/seller, you have the right to know what happened to your money process-wise. Your real estate agent must follow the process required by the Texas Occupation Code, Section 1101.550. Additionally, per this section of the Code, if the real estate agent possesses your earnest money, he or she is obligated to disburse it in a timely fashion when demand is made and the proper procedure has occurred.
Under this section of the code, a real estate agent holding earnest money must disburse the earnest money to the appropriate party by producing the earnest money straight from their bank account.
However, not everyone holding earnest money in Texas is a real estate agent. In fact, if you are working through a title company, the earnest money will be held in an escrow account. This account is directed to disburse the funds when certain terms are met. However, if you are working with a third party, such as a real estate attorney, then Texas law does not apply to how these funds are held, and they may be held in a segregated bank account. In the latter instance, if the earnest money is held by a third party who is not licensed as a real estate agent, then that entity is required to obtain a written agreement, signed by the owner of the funds, authorizing the third party to hold them. If the owner signed a contract, authorizing the third party to hold the earnest money, then there is an enforceable agreement.
What Happens if the Transaction Goes South ?
If a Property Goes to Closing
If the buyer goes to closing, and the contract is fulfilled, the earnest money is applied to the contract. If the buyer does not go to closing, what happens to the earnest money? Generally, the seller will be entitled to the return of the earnest money unless certain exceptions exist.
For example, the earnest money contract may contain a paragraph allowing the buyer to terminate, and provides for the earnest money to be returned if it is so terminated. The most common termination contract to an earnest money contract allows the buyer, within seven days of the day the contract was delivered to the buyer, to terminate the contract for any reason or for no reason. Under these circumstances, if the buyer terminates the contract, the earnest money deposited by the buyer is generally returned to the buyer.
Otherwise, if the sale does not go to closing, the earnest money would typically be paid to the seller as damages unless the contract provides otherwise. For example, in some sales of new homes, the seller may agree to return the earnest money even though the buyer terminates the contract.
If the contract was unilaterally terminated by the buyer (the buyer asserted a contingency), the earnest money is typically returned to the buyer. However, if the seller terminates the contract due to the buyer’s failure to perform, the earnest money would typically be paid to the seller.
If the contract were terminated by mutual agreement of the parties, the earnest money should be returned to the buyer.
If the sale does not close due to a breach by the buyer, causing the seller to, "[cause to be performed] the obligations of the buyer," the earnest money is typically retained by the seller as liquidated damages for breach of the earnest money contract.
If the sale does not close due to a breach by the seller, causing the buyer to, "[cause to be performed] the obligations of the seller" or otherwise, the buyer may pursue any remedy available under law or equity. Under these circumstances, the buyer and seller may agree regarding what happens to the earnest money. If they cannot, the earnest money shall be interpleaded with the court. The interpleader process requires the court to determine the winner of the earnest money.
Steps To Drafting A Valid One
Before drafting an earnest money contract, clients need to have a complete understanding of their obligations under the contract, in addition to having ample information regarding the property that is intended to be purchased. The orientation of this information will be crucial to the contract negotiations. If you are not comfortable with the price that are prevailing in the area and the value of the property, you should consult the advice of a professional such as a realtor or a real estate lawyer.
After some time has passed and negotiations have taken place, an earnest money contract will at some point need to be drafted. Clients should always follow the advice of a legal professional for the terms of that contract, as the terms will vary depending on the specific needs of the clients. The most typical first step is to go over the process with the client in a preliminary meeting, and then draft the contract itself. The most important advice is to not try drafting an earnest money contract yourself. This is a serious legal document, and it is important that you find a professional who is qualified to draft the document.
After the draft has been completed, then the buyer will have an opportunity to review it. When an earnest money contract is drafted, it will have many specific legal terms and phrases that the buyer should be familiar with before they sign. The client will not only have the opportunity to review the document, but also to ask questions about anything that they do not understand. Finally, once both the client and the real estate attorney have been able to discuss the draft, the document can be finalized, and the earnest money contract is signed.
Common Pitfalls
Several common mistakes arise from the use of earnest money contracts. Knowing what they are and knowing how to avoid them can save you a lot of money and trouble.
The first common mistake is failing to have your contract properly filled out.
The most common areas to be filled out incorrectly are:
a. The parties. Common mistakes are forgetting to sign or include the property owners’ full names and signatures.
b. The correct date. This sounds basic, but many times the closing date is either omitted or the wrong date is listed.
c. Correct legal description. Double check that the right property is included. A quick way to assure that is to enter in the address.
d. The title company. If the title company is not listed then no one will be able to tell where the earnest money is being deposited. The buyer will also not be able to ask for an ESTIMATE of closing costs.
e. Closing. The contract should state the date by which the sale will take place. If the sale does not occur before the date listed, the seller may have a claim on the earnest money. Be sure to list a "survive unchanged" clause for all the conditions of the contract to protect yourself.
f. "Time is of the essence" clause. This clause puts emphasis on the importance of complying with dates set forth in the contract and failure to do so may allow the other party the option of terminating the contract and retaining the earnest money deposit.
g . Address of buyer’s agent. If the buyer’s agent does not have an address listed within the contract, the agent will not be able to receive a copy of the contract or any notices therein.
A second mistake made is not making sure no other agreements are tied in with the contract.
If you are utilizing an earnest money contract to purchase a property, ensure that the contract is the only document binding you to the transaction. If more than one contract is included, it may render all of the contracts void ab initio, meaning invalid from the beginning.
There is no penalty for using multiple earnest money contracts when purchasing property, but be careful as it may cause unexpected legal complications, especially when attempting to use one of the contracts at the time of a lawsuit.
An equally important warning is to ensure that the earnest money deposit is made and properly documented.
More often than not, the contract for an earnest money state that "the purchaser pays $X amount of the earnest money deposit."
However, it is not uncommon for a purchaser to attempt to back out of the contract and refuse to forfeit his deposit.
If the money was not either deposited into an escrow account or the seller’s attorney is not holding the money, the purchaser may not be forced to forfeit the deposit.
To avoid this type of occurrence, make sure to document the date that the earnest money deposit was actually made and how.