Due Diligence vs. Earnest Money: What’s the Difference?
LS
Summary:
While both fees act as good-faith deposits, the main difference between due diligence money vs. earnest money is that earnest money is refundable and the due diligence fee is usually not. Earnest money is a common practice in real estate where the buyer pays a percentage of the purchase price to the seller as a show of good faith that they intend to buy the home. A due diligence fee is only common in a few states, but it’s similar in that it provides compensation to the seller in the event that a buyer backs out of the home-buying process.
Say you’ve found a house and you’re ready to make an offer. Hopefully, your real estate agent has prepared you for the fact that you’ll almost always have to pay some cash upfront before you’ve even made it to the closing table.
This is money to show you’re serious about the purchase. In some cases, you may only need to put up earnest money. However, in some states, you’ll also be asked for a due diligence fee. So, what’s the difference? Are these fees negotiable? And do you have to pay them both?
We’ll answer these questions and more. Read on to learn more about the similarities and differences between due diligence fees and earnest money and everything you need to know about these terms to make informed decisions about the home-buying process.
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What is an earnest money deposit?
When you make an offer on a house, you will often need to make an initial deposit, also known as earnest money — toward the purchase price of a home. It’s meant to demonstrate you are serious about purchasing the property. The earnest money deposit is not a law, but it is customary and negotiable. How much earnest money you’ll need to come up with varies but is typically between 1% to 3% of the purchase price.
Its primary purpose is to protect the seller if the buyer decides to back out of the real estate transaction. The buyer can cancel the deal during the contingency or due diligence time period and get their money back. However, if they back out after that time is up, they forfeit the earnest money and the seller gets to keep the deposit.
When you make an earnest money deposit, it’s not paid directly to the seller. Instead, it’s held in an account by a mutually agreed-upon escrow agent. The money will remain in the escrow account until it’s either refunded to the buyer, used toward the purchase price or closing costs, or handed over to the seller if the buyer backs out after the due diligence period is up.
Keep in mind that your earnest money deposit is different from your down payment and mortgage. Once you’ve found your dream home and wish to proceed with the transaction, make sure you have the right mortgage to finance your purchase.
What is a due diligence fee?
Due diligence money is also a type of good faith deposit like earnest money. It’s generally meant to compensate the seller for taking the home off the market during the due diligence period. The due diligence period, which typically ranges from 14 to 30 days, is the time in which a buyer assesses the seller’s home and arranges for a home inspection, title search, and appraisal.
Instead of being held in escrow like earnest money, due diligence fees are paid directly to the seller who deposits it in their own account. Usually, the only way the buyer can recoup that money is if the seller breaches the contract, such as refusing to sell the property after it’s under contract.
Even if the home inspection, for example, reveals hidden structural damage, health and safety issues, or other major problems, causing the buyer to back out of the deal, the seller is within their rights to keep the due diligence money. The only other way the buyer might get it back is if the title search revealed liens or encumbrances that prove the seller isn’t legally allowed to sell the property.
What happens during the due diligence period?
The period of due diligence begins after the sales contract is signed and the checks for due diligence and earnest money are delivered. As mentioned, this is when the buyer begins scheduling property inspections and making sure loan qualification and other details are sorted out.
In general, these are some of the things you can expect to happen during a due diligence period.
- Home inspection, including inspections of structural, plumbing, HVAC, and electrical systems
- Pest or termite inspection
- Property survey and home appraisal
- Title search
- Repair negotiation, if needed
Based on these inspections, investigations, and other factors, you’ll need to decide whether you want to proceed with the purchase or not. Your due diligence money guarantees that you can back out of the sale for any reason (or no reason) as long as you do it within the due diligence period. However, keep in mind that you’ll forfeit the due diligence fee, but you will get your earnest money back.
Pro Tip
Make the most of your due diligence and earnest money by getting all the necessary inspections recommended by your real estate agent or other experts. This way you can make the most informed decision about whether or not this is the right property for you.
How much is the due diligence fee?
The sum of the due diligence money is not a definite amount and can vary depending on the price of the home and the length of the due diligence time. In any case, it’s usually less than half a percent of the asking price. It can also depend on the current state of the real estate market.
For example, in a seller’s market (where there are more buyers than homes to sell), you could expect relatively high due diligence fees in states where they’re more common, like North Carolina. Offering a higher due diligence fee than other buyers can also be used as an incentive for a seller to accept one equally competitive offer over another.
On the other hand, if it’s a buyer’s market — too many homes and not enough buyers — a home purchaser may be able to negotiate a reduced due diligence fee or have it waived altogether.
Due diligence vs. earnest money
Due diligence and earnest money are both deposits that a buyer usually pays when the purchase contract is signed. Though neither is legally required, earnest money is common practice while the due diligence deposit is typically only used in certain regions of the country.
Both the due diligence fee and earnest money deposit are primarily meant to protect the seller. After all, if the seller has taken the house off the market and then the deal falls through at the eleventh hour, the seller is entitled to compensation for losing all that time and having to find a new buyer for the property. However, both due diligence and earnest money provide some protections for the buyer as well.
“Ultimately, earnest money and due diligence fees are both designed to provide protection for the seller. While some may argue that these fees can be seen as a way of taking advantage of the buyer, they are generally meant to protect both parties involved in the transaction,” explains Jon Sanborn, licensed realtor and co-founder of SD House Guys.
Pro Tip
Keep in mind that the fees are negotiable, so each party going into the transaction should be aware of the exact rules surrounding the due diligence fee and earnest money deposit. There shouldn’t be any surprises once the sales agreement is signed.
“It is important to remember that, regardless of the fees involved, it is up to both parties to come to an agreement on terms and conditions prior to entering into a real estate transaction,” adds Sanborn.
The case against due diligence fees
Not everyone is sold on the idea that a due diligence fee is necessary when the buyer is already putting down earnest money. It’s more money upfront that a buyer needs to come up with in an already expensive home-buying process.
Plus, the due diligence money is generally non-refundable (unless the seller breaches the contract), unlike earnest money which is typically refunded as long as the buyer backs out within the due diligence period.
The concept of a due diligence fee is somewhat controversial, and opinions on the matter can vary. Generally speaking, some argue that due diligence fees are necessary to ensure a thorough assessment of potential investments and associated risks, while others view them as an unnecessary added expense. -- Shaun Martin, owner and CEO of The Home Buying Company.Click to Tweet
“If the fee is seen as excessive or unnecessary, then it could be considered shady. Ultimately, it is up to the individual investor to assess whether a due diligence fee is appropriate in their particular case,” Martin adds.
Pro Tip
To avoid any surprises when you’re ready to make an offer, be sure to ask your real estate agent what you can expect to pay in regard to earnest money and due diligence fees, if applicable. The sum of money you’ll need to provide upfront can vary a lot depending on the local market so you’ll want to be prepared.
FAQs
What is a caveat emptor state?
The states, like North Carolina and others, that usually charge a due diligence fee are also typically what is known as “caveat emptor” states. Caveat emptor is Latin for “let the buyer beware,” and it puts the primary burden on the buyer to fully inspect the property for any defects before following through on the purchase.
This differs from most states which require the seller to disclose the overall condition of the home so that buyers can make an informed decision about whether to buy the property.
IMPORTANT! Keep in mind that the seller may not be aware of all existing problems with a property. This means it’s still important for the buyer to complete a home inspection to identify any other issues that aren’t addressed in the seller’s disclosure.
Is due diligence the same as a contingency?
The terms are related, but not exactly the same thing. Due diligence includes the tasks and inspections a buyer should go through to make sure the property is in good condition, suitable to live in, needs no major repairs, and has no title issues. But if the buyer misses something, usually that’s on them, particularly in states that charge due diligence fees.
Contingencies are more specific and must be met for the sale to be finalized. For example, a financing contingency, an obvious one, means that the sale is contingent (dependent) upon if the buyer can secure financing. Another one you’ll see is a home sale contingency, meaning that finalizing the sale of the new home is contingent upon the buyer selling their current house first. Other common contingencies include an appraisal contingency or title contingency.
Key Takeaways
- Due diligence and earnest money are both deposits made by the buyer to demonstrate a strong interest in purchasing the home. These funds also compensate the seller while the property is inspected and removed from the market.
- Neither due diligence money nor earnest money is required by law. That said, asking for earnest money is a common practice, while charging a due diligence fee is only used in a few states, most notably North Carolina.
- Earnest money is generally refundable should the deal fall through within the due diligence period. However, the due diligence fees are almost always non-refundable.
- If all goes well during the due diligence period, both the due diligence and earnest money are typically credited toward the purchase price through the closing costs or the down payment.
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