Payback Time – Earnest Money

Oxymoron: Words used together that have opposite meanings – jumbo shrimp, for example. A seeming oxymoron is nonrefundable earnest money, a euphemism that some sellers use for a deposit that they intend to keep whether or not the sale goes through. A builder, for example, may ask for such a deposit up front to help offset construction expenses. The builder uses the term earnest money to avoid upsetting the buyer – even though the builder has no obligation or intention of returning the money.

Most of us understand earnest money to be a deposit made by prospective buyers as evidence of their intention to complete a transaction. Earnest money is often held by a neutral third party, who awaits word that the transaction has closed before forwarding the deposit to the seller.

Let’s look at a common situation that illustrates the confusion that can occur when a seller refers to a nonrefundable deposit as earnest money. First-time buyers Monique and Alex make an offer on a planned $100,000 new-construction house. The builder insists on using his own contract, and the buyer’s agent explains, “If you want to buy that house, you’ll have to use the builder’s contract, but you should have an attorney review it.”

Monique is afraid an attorney will be costly and that the builder will refuse to revise the contract anyway. The buyer’s agent concedes that in her experience the builder has never changed the contract. “Besides,” says the buyer’s agent, “I’ve sold lots of houses with this builder, and I’ve never had a problem.”

Resigned and trusting, Alex and Monique give the builder a $10,000 nonrefundable earnest money deposit as stipulated in the contract. The builder begins construction.

Then the trouble begins. Alex loses his job. The couple can’t close because their loan is in limbo until Alex finds a new job. The builder says, “Sorry, but we had a contract. If you can’t close, the house is mine, and I need to sell it to another party.” The buyers are in a fix. They’re going to lose their life savings. But the builder has a legitimate issue – he needs to close on the house to recoup his costs.

Alex and Monique sue the builder for return of their deposit.

The builder’s attorney argues that the contract specifically says the money isn’t refundable.

But the buyers’ attorney argues that the parties intended the transaction to be an installment sale because there was a partial payment when the contract was signed and one or more payments were due in the future – in this case, at closing. In other words, the buyers bought the house and the seller is holding title to ensure that the buyers make the final payment.

The attorney argues, in effect, that the deposit payment represents an equitable mortgage. Although this isn’t a mortgage according to the standard use of the term, courts often treat it as one because the parties appear to have set up an agreement in which payments are made over time and the creditor holds an interest in the property as security. The judge agrees.

Based on the decision, the builder would have to foreclose on the equitable mortgage and the buyer would have a limited time to bring the payments up to date. If the buyer did so, the builder would be whole. If the buyer couldn’t pay in time, the buyers would lose their deposit and the builder would get the house and keep the $10,000 deposit.

If you were the judge, how would you decide? Would it make a difference if the payment on a $100,000 house were $1,000 or $10,000? Judges want to provide as much justice as possible to all sides. In every case I’ve tried where the deposit amount was substantial relative to the purchase price, the judge found for the buyer and made the builder foreclose on the equitable mortgage.

Situations like Alex and Monique’s are based in misunderstandings. The builder thought using the term “nonrefundable” would give him security. In the end, he spent many months, and considerable money, settling a dispute. When they signed the contract, the buyers didn’t imagine that the reference to “nonrefundable earnest money” would impact them; then they found themselves in a position of wanting a refund.

Warning: If a judge rules that a contract doesn’t represent an equitable mortgage or the buyers don’t want to pursue a suit against the builder, they may still try to recover their deposit by suing you.

Navigate the nonrefundable earnest money minefield with extreme caution. When you work for buyers:

1. If you see the term nonrefundable earnest money, raise a red flag with your clients.
2. Always recommend that your clients have an attorney review their contract. Even if you believe the seller won’t negotiate terms, the attorney will give the clients sound legal advice, which should also protect you from being asked to shoulder a loss for your clients.
3. Remember that earnest money is typically held by a third party, and a downpayment is held by the seller. Alert your clients to the difference, $so they’re aware that money held by the seller may not be easily recovered.

Armed with a realistic understanding of the semantics behind the term nonrefundable earnest money, your buyers will be spared misunderstandings, and potentially, lost funds.