Making Sense of Due Diligence and Earnest Money

A Due Diligence Fee and Earnest Money are both used as deposits in a Real Estate transaction.

You found one!

After MONTHS of online searches, countless showings, and a number of arguments with your significant other, you have finally found a place you can both agree on. Excited to move forward, you ask your agent to make an offer at asking price for you to submit to the seller, and quickly realize there is more to an offer than you thought once your agent begins asking you what you want the other terms of the offer to be.

In a standard offer to purchase, there are several terms that combine to make the offer. Purchase price is not always the deciding factor for if a seller will accept or not. The terms are purchase price, due diligence amount, due diligence period, earnest money deposit, additional earnest money, closing period, loan type or cash, seller paid closing costs, home warranty requests, included personal property, if the buyer must sell a house to be able to purchase, and anything else that could be included with the offer using an additional addendum.

Most of the sellers I represent are all focused on the same terms when reviewing offers.

  1. Purchase Price
  2. Due Diligence Fee
  3. Earnest Money

So, let’s go over these in more detail.

What is Due Diligence?

A Due Diligence Period is a period of time that the buyer will have to perform any inspections, appraisals, or negotiate repairs. The buyer will determine the amount of time they are going to ask for, and the amount of money they are going to offer, which will be the Due Diligence Fee. The important thing about due diligence is that it provides a time period for a buyer to terminate the transaction and incur no additional costs or fees, the only thing they would lose is the due diligence fee. If they DON’T terminate the transaction, however, then the due diligence fee will be credited back to them at the closing table.

What is the point of Due Diligence?

The point of due diligence is ultimately raise buyers confidence in the home they are purchasing. The buyer can perform any inspections they please, request any repairs they deem needed, and cancel the transaction if they please. The point of the fee is to compensate the seller for this period of time when the buyer can perform any inspections they please, and cancel the transaction and incur no more expenses for terminating the purchase contract.

How long is the Due Diligence Period?

The buyer will negotiate the length of their time to complete any inspections, finish securing financing, and become confident in the home. I typically see 3-5 weeks, depending on how fast the buyer wants to close.

How much is the Due Diligence Fee?

The buyer will negotiate the price in the offer to purchase. There is no set range, but many say that a good rule of thumb is 1% of the purchase price. So on a $350,000 home, that would be $3,500. This is definitely not always the case though. For example, if you are only asking for 1-3 weeks of due diligence, you should be able to get away with a smaller due diligence fee. It is a good idea to discuss this with your real estate expert.

When is the Due Diligence Fee due?

The due diligence fee is due immediately upon going under contract, meaning as soon as the seller signs it. Most of the time sellers will be okay collecting the due diligence fee a day or so after they go under contract.

Is Due Diligence required?

A due diligence period is not required to purchase a property, and if you opt out of that option, you will not need to pay a due diligence fee. You are also not required to pay for the due diligence period. You can ask for a due diligence period without offering a payment for the period, but a listing agent will catch this and likely advise the seller not to accept the offer. So while you are not required to pay for the due diligence period, or have the due diligence period at all, just about every deal in our market does include a paid-for due diligence period for the buyer. You’ll see why as we continue.

Now you may be asking, “Why do I have to pay to be able to do inspections? That seems like a basic right if I am about to spend this much money on a house”. Well the reason is because the due diligence fee actually serves as a down payment in a sense. At any point during the due diligence period, the buyer may back out of the purchase with no repercussions. Meaning that if anything comes up in an inspection, the buyer can get out of the purchase and the only thing they will “be out” is the due diligence fee that they have already paid. The seller will get to keep their due diligence as a way to compensate them for taking their home off the market for the buyers who ended up not getting it. It is also worth noting that if the buyer does NOT back out of the purchase, the due diligence fee will be credited back to the buyer at closing.

What is Earnest Money?

Earnest Money, also referred to as “good will money” is a form of deposit used to show a serious intention to buy- just like due diligence money. As we stated before, if a buyer backs out of the contract DURING the due diligence period, they are allowed to leave and only lose the due diligence fee which they have already paid. They will get the earnest money returned to them. If they back out AFTER the due diligence period has already ended, the seller is entitled to keep the earnest money as well. If the buyer never backs out of the contract, the earnest money will also be credited back to them at closing.

When is Earnest Money Due?

Earnest money is paid by the buyer to the escrow agent a few days after going under contract.

What is the point of Earnest Money?

When you think about it, if a buyer backs out during the due diligence period, it will likely just be a few weeks after they went under contract. That is why the seller will only keep the due diligence to compensate them. If they back out after the due diligence has ended, it is likely that the home has been off the market for over a month at this point. That is why the seller will be entitled to keep both the due diligence and the earnest money- they are being compensated for more time lost. The home has been off the market longer, meaning the seller has been making more payments towards the mortgage and missing out on everyone else who could have bought it, so the seller is compensated more.

How can you use this to determine your offer?

If you are getting a very well maintained home or a new construction, you may feel that there can’t be anything on the inspection that would be enough to make you back out. At that point you may want to offer more due diligence and earnest money, or perhaps ask for a shorter due diligence period. On the other hand, if the home you are looking at isn’t in the best condition, you may want to be pretty conservative with these deposits, as an inspection can show a serious issue that affects your decision to buy.

Of course, there are other things to consider as well. You don’t want to offer so much due diligence that if you lose it, you can not afford to make other offers on different properties. Your agent will also be in your corner to help assist you with your offer. They are a resource of knowledge and experience and of course I always recommend you run any questions or concerns by them first.

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