Earnest Money vs. Down Payment: What are the Differences?
EA
Summary:
The difference between an earnest money deposit and a down payment is that an earnest money deposit is a guarantee to the seller, while a down payment is a guarantee to the mortgage lender. Earnest money deposits typically range from 1% to 5% of the purchase price, while down payments typically range from 3% to 20% of the purchase price. A buyer’s earnest money deposit is not an additional cost but rather a part of the total money put towards a house. At closing, the buyer can choose to put the earnest money towards either the down payment or closing costs.
Buying a house is an exciting milestone in a person’s life. But if you’ve never bought a house before, you may find the process to be complicated and confusing. The better informed you are on what buying a house entails, the better decisions you can make for yourself along the way.
You’ll want a stellar real estate agent and mortgage lender on your team to help guide you through the process. Keep reading to learn about what earnest money and down payment mean for you in the real estate transaction process.
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Key definitions
To understand the difference between an earnest money deposit and a down payment, you’ll need a solid understanding of some common real estate terms. We won’t bore you with an entire glossary of real estate terms, just the ones directly applicable to this topic.
- Title. This is a document that certifies the legal owner of a property.
- Purchase agreement. A purchase agreement is a legal document that details the terms and conditions associated with the transfer of real estate title. It contains the home’s purchase price, earnest money deposit, down payment requirements, a mortgage contingency clause, and more.
- Escrow. Escrow is a legal arrangement through which a home purchase is completed. A third-party agent called an escrow agent facilitates the legal process of passing assets and funds between buyer and seller. Once all conditions of the purchase agreement are met between both parties, escrow can close. A typical escrow period is around 30 days.
- Closing costs. Closing costs are all the costs associated with closing on a house. This can include mortgage service fees, appraisal costs, fees for any real estate agents, attorney fees, underwriting fees, and more. These costs are separate from a down payment. The amount depends on the purchase price and location.
- Mortgage. A mortgage is a type of loan secured from a mortgage lender that provides funds to purchase a property. The borrower pays down the balance of the loan monthly over a set amount of time. Mortgage payments include principal, interest, taxes, and insurance (PITI). Typically, the house acts as collateral for the mortgage. This means that if the borrower doesn’t make payments or defaults, the bank takes ownership of the home (also known as foreclosure).
With these definitions in mind, let’s dive into what roles earnest money and down payments play in the home-buying process.
What is earnest money?
Earnest money is a deposit of 1% to 5% of a home’s purchase price that buyers make to show they are serious about purchasing a property. You may also hear it called a good faith deposit.
The purchase agreement outlines the amount of earnest money the buyer will deposit. Either the seller’s real estate company, a title company, a dedicated escrow agent, or the seller’s attorney holds the money during escrow.
In most cases, the buyer deposits earnest money into an escrow account. Escrow accounts typically exist to protect the buyers’ earnest money or to hold the homeowner’s property tax and insurance funds during escrow. This way, there is no chance of either party misusing funds.
Is earnest money required?
No, earnest money deposits aren’t required. However, if a buyer wants to appeal to the seller, earnest money can help. In a competitive real estate market, buyers need to stand out. Anything they do to demonstrate their intentions can help them get their offer accepted.
Contingencies and earnest money
A set of contingencies in a purchase agreement protect the buyer’s earnest money. If the seller meets the contingencies, the purchase’s status changes from contingent to pending. If the seller fails to satisfy these contingencies, the buyer may back out of the contract and get their earnest money refunded.
An experienced real estate agent or real estate attorney can help you make sure your purchase agreement contains all the necessary contingencies. Here are some of the most common and important contingencies:
- Home inspection contingency
- Clear title contingency
- Home appraisal contingency
- Mortgage financing contingency
- Home sale contingency
Pro Tip
The worst day to close on a house is Friday. Check out this article from SuperMoney to find out why.
Where does earnest money go after escrow?
When people say they’re “in escrow,” this means that they’ve made an offer on a home, the seller accepted the offer, and both parties signed a purchase and sale agreement. During escrow, the buyer will usually make an earnest money deposit, complete the final inspections and negotiations, and meet other conditions as outlined in the purchase agreement.
Once all this is completed, they then get to close on the house, meaning they now hold the title of the home. The earnest money is then typically released back to the buyer to put towards either the closing costs or down payment.
However, it doesn’t always go this smoothly. Once the buyer and seller sign a purchase agreement, typically one of three outcomes happens.
- The sale goes through. Just as described above, if all goes according to plan, the escrow money is typically applied to the down payment or closing costs.
- Failed contingencies. If any of the contingencies are not met, the buyer can pull out of the deal and get their earnest money back.
- The buyer backs out. If the seller holds up their end of the deal and all contingencies are satisfied, but the buyer just decides they don’t want to go through with the purchase for some reason, they can withdraw from the sale. In this case, the seller gets to keep the earnest money.
Pro Tip
Typically in hot real estate markets, a buyer might make a non-refundable earnest money deposit. If this is the case, the seller gets to keep the money regardless of what happens. This can help make a buyer stand out to the seller, but it’s risky. Discuss this option with your real estate agent to decide whether this is a good move for you.
What is a down payment?
A down payment is a percentage of the purchase price that the buyer pays upfront. The buyer pays the down payment at closing through a wire transfer, money order, or certified check. The amount of cash a buyer puts toward the home purchase isn’t included in his or her mortgage loan. However, the type of mortgage loan can dictate the down payment amount.
Loans and down payments
Each type of loan may require a different minimum down payment. Down payment amounts are described in terms of a percentage of the overall purchase price. Here are a few common types of loans and their down payment requirements:
- Conventional loans. Conventional loans require a 3% to 20% minimum down payment. The percentage required depends on your financial situation, the mortgage lender, and if you are a first-time homebuyer.
- Federal Housing Administration (FHA) loans. FHA loans require a minimum down payment of 3.5%, depending on factors such as your credit score and debt-to-income ratio. They come with a few additional requirements for the property and higher mortgage insurance premiums than conventional loans.
- Veterans Administration (VA) loans. If you served in the United States military, you may be eligible for a VA loan, which requires 0% down and no mortgage insurance.
To compare the different mortgage loans available to you, take a look at the list below. You can filter your options as well depending on the type of mortgage you’re looking for.
Pro Tip
If you’re a first-time buyer, you may be eligible for a lesser down payment with a conventional loan. Discuss your options with your real estate agent and mortgage broker. Keep in mind that a down payment of any less than 20% may subject you to private mortgage insurance premiums and higher interest rates.
Earnest money vs. down payment
Though the two are related, an earnest money deposit and a down payment are very different concepts. Here are the key differences between the two.
| Earnest money | Down payment | |
|---|---|---|
| Purpose | A payment from the buyer to the seller meant to show the seller that the buyer isn’t wasting the seller’s time. | Money that comes from the buyer, not the mortgage lender, and is used to pay for the house upon closing. |
| Amount | Usually 1-5% of the purchase price | In 2021, the average down payment was 7% for first-time homebuyers and 17% for repeat buyers. |
| Method of payment | Usually, earnest money is wired into an escrow account or seller’s agent. | Down payment goes directly to the buyer via wire, check, money order, or cash. |
| Optionality | Optional | Usually required |
| Due date | Due within three days of signing the purchase contract | Due on closing day |
Earnest money and down payment come together at the closing of real estate transactions. It’s common for buyers to put earnest money towards a down payment or closing costs. As such, earnest money can turn into a down payment, but a down payment can never be earnest money.
FAQs
Is earnest money refundable?
Earnest money is refundable to the buyer if the seller fails to meet contingency requirements.
Who gets to keep the earnest money?
This depends on the outcome of the real estate transaction. If the seller doesn’t uphold the contract terms, the buyer can back out and take the earnest money. If the deal closes or the buyer backs out for any other reason, the seller can keep the earnest money.
What if I don’t have earnest money?
If you, as a potential buyer, don’t have earnest money, you should consider if you have down payment money. A home purchase is a huge financial commitment that you want to make sure you are ready for.
Speak with your accountant to assess your financial readiness and see where you can pull funds from for earnest money.
Key Takeaways
- Earnest money is insurance for the seller. Once a purchase agreement is signed, the buyer deposits earnest money into the escrow account or seller’s agent to show they are serious about buying the home.
- Once the deal closes, the buyer can put the earnest money towards the down payment or closing costs. If the deal falls through due to the seller not meeting purchase agreement contingencies, the buyer can take the money back. If the deal falls through due to the buyer backing out for any other reason, the seller keeps the money.
- A down payment is money put towards a house upfront by a buyer that is excluded from the mortgage loan. Down payment requirements depend on the type of loan. Minimum down payments for a single-family home range from 0% for a VA loan to 20% for a conventional loan.
- Earnest money and down payment are two different parts of a real estate transaction. Earnest money can turn into a down payment once escrow is closed. However, a down payment cannot be earnest money.
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