What’s the Difference Between a Down Payment and Earnest Money?
Like any industry, the business of purchasing a home attracts jargon and real estate terms you may not be familiar with. This can add extra and unneeded confusion to the home buying process.
When you are making one of the most significant financial commitments of your lifetime, you need to fully understand the process, so you avoid problems. The terms “down payment” and “earnest money” can be confusing if you aren’t in the industry. They involve a considerable expense on the part of the buyer, so you need to have a good understanding of what they mean.
As an agent who has been selling real estate for thirty-three years, I can tell you wholeheartedly that first-time buyers confuse these terms all the time. The fact of the matter is there is a difference between a down payment and earnest money.
What Is an Earnest Money Deposit?
The earnest money is the amount of money that you offer as a deposit to the seller when making an offer. This gives a guarantee to the seller that you are genuine and allows them to take the house off the market with more confidence. This money is put into an escrow account and shows good faith on the part of the buyer. An excellent way of looking at earnest money from the buyer’s standpoint is having some skin in the game.
When a buyer does not perform under the contract, they risk losing their earnest money deposit. Obviously, a buyer never wants to lose money, but the seller doesn’t want to take their home off the market either with a buyer who isn’t going to proceed with the transaction.
How Much Earnest Money Deposit Will the Seller Want?
Ordinarily, expect to have to pay between 1 and 5 percent of the purchase price into escrow. This can vary based on the real estate market in your area and can go up to about 10 percent if it is new construction.
How a buyer is going to finance the purchase can also be a factor. For example, if the standard earnest money deposit in your area is five percent, but the buyer is using FHA financing, where they will only be putting down 3.5 percent for their mortgage, often the deposit will be relaxed to match their down payment.
Be prepared, however, that not every seller is accommodating.
What Is the Earnest Money Process?
A check for the earnest money will be needed when the purchase contract is signed. In some states, a buyer will put earnest money down when they sign an offer on a home and then again when they sign a purchase and sale agreement. Not every state has one real estate contract. When this is the case, the initial earnest money deposit typically only amounts to $500 or $1000.
This check shouldn’t be given to the seller. Instead, the seller’s real estate company or the title company will hold onto it. This check may not be cashed by anyone but the escrow agent. It will remain there until either the sale closes or the buyer backs out of the deal. If the sale continues to closing, this deposit will then go towards the down payment or closing costs.
If the sale falls through, this deposit could be forfeited by the buyer if the sales contract doesn’t allow them to get it back. There should be clauses in the sales agreement, which provides circumstances where the buyer can leave the agreement with their earnest money returned to them.
As a buyer, you need to be aware of what the contract says and how it allows you to get your deposit back. Usually, the escrow agent cannot unilaterally return an earnest money deposit to a buyer or give it to a seller.
Sometimes it will be blatantly obvious who should get the funds, but if it is challenged by one of the parties, they cannot just release the money. Typically when there is an earnest money dispute, a court of competent jurisdiction will determine who gets the funds.
It should also be known that when you are selling a home without a Realtor as an FSBO, it is typical for the seller’s attorney to hold the money in their escrow account until closing.
How Is a Down Payment Different to Earnest Money?
The down payment goes directly to the seller of the property. It is paid at closing, generally with a bank transfer or cashier’s check. It also differs from an earnest deposit as it usually is more money, sometimes a lot more. Down payments typically range anywhere from five percent to twenty percent. It is possible, however, for it to be a lot more. On occasion, buyers will want to keep their mortgage to a minimum and finance a much smaller amount of money.
Do You Really Need to Pay 20 Percent?
A 20 percent down payment is often going to be difficult for many homebuyers to find. This is particularly true of first-time buyers. Fortunately, this isn’t always the case now with options to put down as little as just 3 percent. There has been a myth floating around for years that you need to put twenty percent down. It is entirely false.
The amount you will need to pay for a down payment will largely depend on your lender, though it can also affect the chances of the seller accepting your offer. There are many financing options available to make home-buying easier; most banks will be able to offer mortgages with less than 20 percent down.
If you do purchase real estate with a lower down payment, the lender may require that you pay private mortgage insurance. This is a significant ongoing charge in addition to your mortgage payments and could amount to 1 percent of the loan. This would mean that you will be paying an extra $3,000 on a $300,000 mortgage each year.
Final Thoughts
Owning your own home or investment property is a milestone in anyone’s life, but the costs of purchasing need to be carefully accounted for. You need access to substantial funds so that you can pay all the closing costs as well as earnest deposit and down payments. Now at least, you should have a better understanding of some of the terms used when purchasing a home as well as the costs involved.
Hopefully, you now have a better understanding of how a down payment differs from earnest money deposits.
This article has been contributed by Bill Gasset.