Tips for a Smooth Security Deposit Approach

Introduction

The security deposit is an age-old staple of the rental industry. Collecting this upfront charge is basic practice for property managers, and while PMs don’t always love security deposits, it’s a must-have process in order to protect your investor, their property, and your business. The right way to approach security deposits is entirely dependent on what works for your company, the type of property you rent, and the state and locality in which you manage. 

The variation in security deposit law from state to state, and even in certain cities and counties, can create a bit of a headache, as can ensuring compliance with those laws in the hectic day-to-day of the property management industry. The demand for relief from the friction of security deposits has grown, as has the regulatory environment surrounding them. New options for property managers are continually hitting the market. Many property managers still opt for traditional deposits, but the playing field is more complicated than it’s ever been. 

Here, we’re going to cover security deposits from top to bottom, including how they work, how much you may charge, applicable laws and how property managers can avoid legal trouble, and alternatives to the traditional security deposit. 

Disclaimer: This is not, and shall not be construed as, legal advice. The topics discussed herein may not include all relevant laws and regulatory requirements. Any information contained in this blog is provided for informational purposes only and should not be construed as legal advice on any matter. This is especially true given that laws change on a regular basis. You should review specific security deposit laws for your state in detail to make sure you have the most up-to-date information available and consult with your local counsel for applicability to your property. Unaffiliated products and service providers listed herein are not endorsed by Second Nature Brands, Inc., nor any of its subsidiaries or affiliates, and we recommend that you conduct diligent review of any such products and providers.

Determining the right security deposit amount

State law, and some local ordinances, put a cap on how much you’re allowed to charge for a security deposit, so the first step to answering this is to know what is legal. For example, in North Carolina, a property manager can legally charge up to two months of rent for a security deposit if the lease term is longer than month-to-month. Other states will have different laws. In Michigan, the cap is 1.5 times rent. In Alabama, a security cannot exceed one month’s rent for an unfurnished unit, but can be up to two month’s rent for a furnished unit. The first step is to know the law and document anything that could feasibly be challenged. It is also important to note that federal law may apply to rental housing that is subject to the federal housing authorities through use or receipt of federal funds, and such law may set varying limits on security deposits as well.

It’s pretty standard to charge one month of rent for a security deposit, but there are certainly situations where you might change that approach. You’re focused on risk management here.  Residents who have a recent eviction, an extremely low credit score, or a lack of rental history may justify a higher security deposit, if allowed under applicable law. The security deposit is ultimately protection from unpaid rent, damages, or anything you’re due that you otherwise could not collect, so risk assessment can help determine how much protection you may need to obtain. 

On the reverse side of things, you may charge a lower security deposit to a low-risk resident or to lower the barrier to entry for lower income residents. Move-in cost is often the largest burden on a prospective resident, and lowering that burden represents a tradeoff between risk and days on market. Some property managers will offer very low deposits for Class C properties in an effort to get those properties filled faster. It is important, however, to note that property managers must adhere to fair housing laws in assessing security deposits and ensure they are acting in fairness and good faith with all tenants.

Security deposit alternatives

Security deposits are often seen as a necessary evil by property managers. They can create extra administrative overhead for property managers and prohibitive upfront costs for prospective residents. In recent years, some vendors and property managers have sought solutions to this problem, and multiple alternatives to deposits are beginning to gain popularity.

The inherent challenge in establishing a viable alternative is lowering the barrier to entry while simultaneously protecting against damage expenses. Let’s take a look at some budding alternatives to security deposits that aim to do just that. Certain state and local laws may also apply.

Insurance

Typical insurance is a simple policy taken out by the resident to cover damages to the property that might occur during their occupancy.

Typical insurance removes the barrier that the security deposit represents, which is a win for property managers looking to decrease days on market. It was one of the first new products to come about when vendors identified an opportunity in the security deposit world. The biggest potential downside to true damage insurance is that the resident no longer has a monetary incentive to treat the property well, since they are no longer financially liable for damages, and the amount and type of damages that can be covered may still be limited by law. While you may eventually recoup repair costs from the insurer, excessive damage might still lengthen your turn time.

A separate concern with insurance programs is that many options on the market today are not actually insurance. Instead, they act more as security deposit waivers, wherein the insurance company will move to collect damages from the resident after a payout. This can create friction, as the term “insurance” can create false assumptions from the resident, resulting in a negative experience.

Surety bond

Surety bonds are agreements between two parties managed by a third party, known as the surety. In the case of property management, the contract is between you as the property manager and the resident. It states that the resident agrees not to damage the property and agrees to cover damages should they be responsible. In case of a contract breach at the end of the lease, the surety pays out the sum required to the property manager, then bills the resident the cost of the damages.

The surety bond removes the lack-of-incentive issue that arises with some insurance programs, while also solving many of the problems with traditional security deposits. The reason some property managers balk at this solution is a fear that the model itself is unsustainable. Difficult collections processes for the surety could cause price increases and a lack of stability in the industry. In addition, the amount and type of damages that can be covered by a surety bond may still be limited by law.

ACH authorization

An ACH authorization acts as a direct draft agreement from a resident’s bank account, similar to a hotel’s “credit card on file” policy. Basically, it can be used to cover damages without an upfront payment or lengthy collection process.

An ACH authorization effectively removes the barrier to entry and has potential for a better collection rate than something like a surety bond. Not all residents will have the available funds to qualify for this, though. It is one of the most reliable security deposit alternatives if you can activate it. It is important to note that the amount that may be charged may still be limited by law.

In-house program

Some property management companies prefer to operate their own security deposit alternative in-house. For most companies, this takes the form of a waiver fee that residents can pay in lieu of a security deposit. It doesn’t cover damages or provide insurance, but it means they don’t have to pay the full security deposit upfront.

The big win here for property managers is the added profit from the waiver fee, since, unlike a traditional security deposit, it’s nonrefundable. It is critical to be clear here that the fee does not cover anything other than the right to not pay a deposit. The potential pitfall with this approach is that the property manager still has to collect from the resident if the property is damaged.

Many property managers that have tested this have seen positive results, but communication is absolutely critical to ensure residents understand that the fee does not exempt them from future damage charges. Again, this alternative may also be subject to certain laws where the property is located.

A note on last month’s rent

Some property managers charge one additional month of rent at move-in, which then covers the final month of residency in the property, if permissible by law.

It’s important to know that last month’s rent is not a security deposit alternative. It’s relevant here because it affects how much you can charge for a security deposit. Some states have limits on what total move-in fees can be, so if you charge last month’s rent, you may be more limited in what you can charge as a security deposit. Also, if you label an upfront payment as “last month’s rent,” it cannot be used as a security deposit. Further, it can create headaches in the event of a rent increase. For all these reasons, this practice is generally not recommended.