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What Is Due Diligence and Earnest Money When Buying a Home?

tl;dr

What You Need To Know

  • Earnest money is a “good faith deposit” the buyer makes to demonstrate that they’re ready to buy a home
  • The buyer can pay a due diligence fee to the seller to buy time for home inspections without losing their earnest money
  • While most real estate transactions require earnest money, a due diligence fee is more commonly used in “buyer beware” markets

Contents

You’re ready to buy a home. You’ve put in an offer and the seller has accepted it. Congrats! Now, you’ll be expected to pay a small sum of money upfront to:

  • Show the seller that you’re serious about buying their home
  • Make it worthwhile for the seller to take their home off the market 
  • Provide an incentive for the seller to let you schedule a professional home inspection

These upfront payments can take different forms. The two most common are the earnest money deposit and the due diligence fee. 

Earnest Money Deposit: The Expected Upfront Payment

In most real estate transactions, the buyer will pay a small percentage of the purchase price as an upfront deposit on the house after their purchase offer is accepted by the seller. There’s no law saying that earnest money is required, but it’s a fairly common practice.

This earnest money deposit is a sign of good faith that the buyer is interested in buying the home and has the money to do it.

The seller doesn’t get the deposit. It’s put into an escrow account (usually through the title company or lawyer). Neither the buyer nor the seller can access that money.

If the sale goes through, the money is applied to the purchase price of the home.

If the sale falls through, what happens – and who gets the money – depends on what the buyer and seller agreed to based on the “contingencies” (legal escape routes for the buyer and seller) in the purchase agreement.

How much earnest money should a buyer pay?

There’s no standard amount that needs to be paid in earnest money. 

Instead, payments tend to be based on the local market and are negotiated by the buyer and seller. As a rule, buyers usually pay between 1% – 3% of the purchase price. 

What happens to earnest money if the deal falls through?

It all depends on the negotiated contingencies in the purchase agreement. The contingencies should make it clear when either party can back out of the contract – and who keeps the earnest money in each scenario. 

Some common contingencies include:

  • The financing contingency: What happens if the buyer can’t get a mortgage before closing?
  • The home inspection contingency: What happens if there are problems with the home that may cost more to repair than the buyer can afford?
  • The appraisal contingency: What happens if the home appraisal finds that the home is worth less than the sale price, and the seller isn’t willing to negotiate?
  • The home sale contingency: What happens if the buyer can’t afford to buy the seller’s home because they can’t sell their own home first?
  • The title search contingency: What happens if a title company search shows that the seller doesn’t have the right to sell the home?

Due Diligence: The Buyer Beware Payment

A due diligence fee works a little differently from an earnest money deposit. 

Unlike the earnest money deposit, the buyer pays the due diligence fee (usually between 0.1% – 0.5% of the house’s purchase price) directly to the seller. 

The fee starts the clock on the due diligence period. During that time, the seller agrees to take their home off the market (usually 14 – 30 days) while the buyer schedules a home inspection(s).

The buyer may schedule a(n):

  • Home inspection: This is a thorough inspection performed by a licensed home inspector. 
  • Specialized inspection: This can include a termite inspection by an exterminator or specialized inspections by a plumber, electrician, HVAC contractor or other specialists.
  • Title verification: The buyer can request a title search verification to ensure that there are no outstanding liens or legal claims of ownership on the property.
  • Homeowner association (HOA) review: If the home is part of an HOA, the buyer can request the HOA’s guidelines for review.
  • Appraisal: The buyer’s lender will likely request an independent appraisal of the home’s value. If the appraisal value is significantly lower than the sale price, the lender may not approve the mortgage.

After any inspections and reviews are completed, the process can play out in 1 of 3 ways:

If the buyer …Then the seller …
Agrees to move forward with the saleApplies the due diligence fee and earnest money deposit to the sale of the home
Backs out of the sale during the 30-day windowKeeps the due diligence fee BUT returns the earnest money
Backs out of the sale after the 30-day windowKeeps the due diligence fee AND the earnest money

Due Diligence Fee: Where and When It Matters

A due diligence fee isn’t always required. You may have to pay it depending on the area where the home is being sold and whether it’s a buyer’s market or a seller’s market.

‘Buyer beware’ states

Alabama, Arkansas, Georgia, North Carolina, North Dakota, Virginia and Wyoming are “caveat emptor” states. (That’s a fancy way of saying “buyer beware” states.) 

In “buyer beware” states, the seller is under little or no obligation to disclose any potential problems with the home they’re selling. That usually means the buyer needs to be especially thorough with inspections to avoid buying a home with a potentially expensive problem. 

Due diligence benefits the home buyer because it allows greater flexibility when scheduling home inspections compared to a home inspection contingency.

Also, while a contingency agreement usually allows a buyer to walk away if there are problems that may cost more to repair than the buyer can afford, due diligence allows the buyer to walk away for any reason.

This gives the buyer more options to avoid buying a house that is stable now, but could be prohibitively expensive in the near future.

Use of due diligence can vary from state to state and real-estate market to real-estate market. Buyers like it because it gives them more time to look for problems and sellers like it because it puts money in their pocket, even if the home doesn’t sell.

Negotiating in a seller’s market

In a hypercompetitive seller’s market, a due diligence fee can also help a buyer inch their offer over the top. 

Let’s say that three buyers, Alex, Cameron and Casey, offer the same amount for a house and all three of them pay the seller’s requested earnest money deposit.

The amount each one offers to pay for their due diligence fee could make all the difference. If Alex offers to pay a bigger due diligence fee than Cameron or Casey, Alex’s offer will likely be seen as a more competitive offer by the seller.

Earnest Money vs. Due Diligence Fee: A Side-by-Side Comparison

Earnest MoneyDue Diligence Fee
Refundable?Yes (depending on purchase agreement contingencies)No (unless the seller doesn’t fulfill their obligations)
Negotiable?YesYes
Who accepts the money?Deposited in escrowPaid to seller
Credited toward purchase at closing?YesYes
How much will it cost?Between 1% – 3% of home valueCan be a flat fee or equal $100 – $500 for every $100,000 (0.1% – 0.5%) of the purchase price
How common is it?Not legally required, but standard practice for most home salesUsually requested at the seller’s discretion (most likely requested by the buyer in a “buyer beware” state)

Whether a seller requests earnest money, a due diligence fee or both, understanding how they work can protect your interests – and potentially, your money – during the home buying process.

As a buyer, you should want to make sure that the time, money and effort you’ve put into buying a house is worth it. Make your earnest money deposit and due diligence fee worthwhile by getting detailed inspections done on the house so you can make an informed decision about buying – or not buying. Otherwise, you may run the risk of losing both payments.

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In Case You Missed It

Take-aways

  1. Your ability to back out of buying a home – and keep your earnest money – is based on the contingencies in the purchase agreement
  2. If you’re paying a due diligence fee, get the necessary inspections done during the due diligence period
  3. In a seller’s market, a due diligence fee can help “sweeten” your offer and push it past the competition

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