Understanding Due Diligence and Earnest Money on the NC Offer to Purchase and Contract
A no-nonsense review of due diligence and earnest money in the NC Offer to Purchase and Contract
In 2011, the North Carolina Real Estate Commission introduced a revised Offer to Purchase and Contract (always seeking to protect consumers) and with that, a new term called "due diligence." Well, change doesn't come easy, and this new concept and contract came with its own challenges for many NC Realtors either. However, once you understand it, it's pretty cool and is definitely designed to protect both real estate buyers and sellers.
Prior to 2011, "earnest money" was the only money that was paid up front.
Earnest money was put in place primarily to show "earnestness" from the buyer and as a way to compensate the seller for their lost time and opportunities (from other prospective buyers) if the buyer "flaked out." As long as everything went fine and the deal went to closing, the earnest money would be credited back to the buyer at closing and everyone was happy. However, things don't always go smoothly. Buyers and sellers were sometimes left out in the cold. Let me explain...
See, the earnest money would be returned to the buyers if their financing fell through for any reason. This could be due to the loss of their job or many other reasons related to their debt to income ratios changing, or even a mistake by their lender.
Now, this is where the big problems came for the sellers. Their home had been off the market (while under contract) for three weeks to a couple of months waiting for this deal to close. Then at the last minute, the buyer's financing fell through, and the seller would be left standing there with nothing to show but hardship, lost time, lost opportunities, etc. And the buyer would be on their way with their earnest money in hand. You can probably imagine how devastating this could be to sellers.
On the flip side, sellers were not the only ones that could be hurt.
Buyers could also get their earnest money back if inspections had been done (the buyer's cost) with requests for repairs, and those requests were not met. Great for the buyer, right? Well, not exactly. See, while the buyer had a right to back out of the contract AND get their earnest money back, they were still left with lost time and the cost of the inspection ($350+). Additional costs may have also been incurred with a lender ordered appraisal ($300+), survey ($350+) or any other arrangements or incurred costs. The buyer could "stick in there" and continue on, but they're left with one or more things that will eventually have to be fixed on their dime.
Well, to help remedy these situations and others, the NC Real Estate Commission developed a revised Offer to Purchase and Contract in 2011. The new offer still implemented earnest money but also introduced a "due diligence fee" and "due diligence period."
The due diligence fee is the amount paid by the buyer directly to the seller, which the seller deposits and keeps.
If the deal closes, the buyer will have that amount credited back to them at closing. But either way, that amount up front is the seller's to keep. In addition to the due diligence fee, there is an agreed upon due diligence period. The DD fee allows the buyer to conduct "due diligence" at the buyer's expense (inspections, appraisals, review of documents, survey, financing, obtaining insurance, etc) within the due diligence period and gives them the right to back out for any reason. The kicker is that, if they're going to back out of the contract for whatever reason, they need to do so prior to the end of the due diligence period. Otherwise, they will not only have lost their due diligence fee but also their earnest money that was put up (and held in escrow). This is because with the new contract, there is no longer a financing contingency. If the buyer backs out prior to the end of the DD date, they will at least get their earnest money back.
With the new contract, the buyer is given more freedom, and the seller is protected from being left empty handed at the last minute if financing falls through.
Strategies for dealing with and negotiating the due diligence and earnest money amount
As a NC/SC buyers agent
When representing the buyer(s), I want the DD fee and earnest money amount to be as low as possible without insulting the seller or giving the appearance that we're wasting people's time. The lower the amounts, the lower the risk of loss for my buyer. In addition, I want the DD period to be extended out as far as possible. The longer the period, the longer my buyer has to do his/her due diligence and feel comfortable that everything will be just fine with their loan, etc.
What if inspections are done, and my buyer is responsible for the cost of those inspections then the seller says, "I'm not fixing anything so you can just take your earnest money and go"? Well, because of this, I DON'T always order inspections right away. I might have inspections scheduled two to three weeks out. Then if the seller refuses to fix one or more things, at least they've got a few weeks invested of their home being off the market and might be more inclined to work with the buyer to resolve the repair issues. In addition, this gives my buyer more buffer room to get comfortable that his/her financing will be secured. Hopefully, they have a really good idea of the likelihood of their financing going through prior to having inspections, appraisals, and surveys ordered. If that's the case, then they've only really lost the due diligence fee.
It's very important to ALWAYS keep track of this DD date (I put it in my calendar with reminder notifications). If more time is needed, go back and try to negotiate a date extension with the seller (they'll usually work with you if you've been proactive) PRIOR to the DD date ending. If you don't then you can risk the earnest money as well.
Also, please note, prior to ever even submitting the initial offer for my buyer, I've already asked the listing agent many questions and probed the best I can. I try to find out the seller's motivation for selling so I can determine how eager they are. I also inquire whether the seller will be prepared for the repair requests that will likely be coming their way. I do my own due diligence so to speak.
As the listing agent
When representing the seller, I want the DD fee and earnest money amount to be as high as possible. This says to me that the buyer HAS some cash, is serious (earnest) about making this work and is willing to risk higher amounts. And of course, if something does happen, my seller will be compensated just a little bit better. Also, I want the due diligence period to be as short as possible. A shortened DD period gives me confidence in the buyer's willingness and abilities to make things happen. It shortens the length of time that my seller's home is off the market should the deal fall apart.
Please note, the greater the amount of the DD fee, the longer DD period my seller might entertain. The smaller the amount off the DD fee, the quicker my seller will want to see the buyer conducting their due diligence.
Hopefully, this provides clarity on the subjects of due diligence and earnest money. If you have any specific questions, please contact us.
(Update: As of December, 14th, 2020), this entire article still applies exactly as it did when originally written. - Chad H)