A Modest Proposal – Earnest Money in New Construction

This article concerns one of those things we do because we have always done so.  As we all know, lawyers do many things because “that’s the way we have always done it”.

The continued solvency of residential home builders is no longer a given.  In 2007 a major builder went out of business, leaving half-finished construction to be completed by others, if at all.  Last year another major builder also failed.  While this phenomenon is hardly new, and the troubled market place has brought the issue of continued financial stability of lenders and builders into sharp focus, builders expect buyers to continue to do business as it has always been done, with deposits (other than for newly constructed condominium properties) being given directly to builders to be spent, saved or squandered by the builder, but not to be held in escrow.

Why should buyers of residential new construction take such risks?  Simply because they have always done so?  To “keep costs down”?

Builders have argued for years that buyers should absorb some of the costs of construction to reduce ultimate costs.  The deposits help defray construction loan expenses that would otherwise be incurred.  In the current market they would urge buyers to deposit an even higher percentage of the sales price on the theory that skittish lenders have reduced the “Loan-to-Value” ratios on such construction, making less money available to complete the project.  But should buyers jump in where lenders fear to tread?

A modest proposal for buyers of new residential construction would be to take the same position that they would take if they had decided to purchase a newly constructed condominium unit or an existing structure not being offered by a builder.  The earnest money should remain in escrow until closing, to insure that the buyer does not lose the deposit to a secured creditor of an insolvent builder in the event of bankruptcy or foreclosure.

The Illinois Condominium Property Act requires that deposits on newly constructed condominium units be kept in escrow.  Custom and usage in the purchase of an existing residence calls for earnest money deposits to be placed in escrow until closing.  Why should non-condominium new construction be any different?

Builders routinely want buyers to “have some skin in the game”.  The risk to the buyer whose deposit is exposed lessens the buyer’s negotiating power.  There is a psychological advantage to the builder more accustomed to dealing in such “numbers”; buyers whose money is “locked” into such a deal are likely to be more compliant when delays result or issues arise concerning workmanship and materials.  And builders without access to buyers’ deposits need to put additional cash into each house, or borrow even more than before.  But in such a scenario, should buyers take on the role of secondary lender?

One way to provide for compensation to the builder who does not have access to a buyer’s deposit is to calculate the additional construction loan interest a builder would incur on account of the unavailability of the buyers’ deposits and to add that amount (or an amount negotiated by the parties) to the purchase price.  The author submits that some buyers, faced with the issue of lack of security of such deposits, may be willing to add additional cash on the “back end” to protect their deposits on the “front end”.

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